This op-ed was originally published in Green Central Banking, on 15 March 2024.
On Wednesday 13 March 2024, the European Central Bank (ECB) announced changes to its operational framework, the toolbox it uses to implement its monetary policy. Think of it like the control panel of a car, with the ECB adjusting the settings (interest rates) to keep the car (financial conditions and prices) running smoothly. The operational framework relates to how the ECB adjusts these settings, which is to say the mechanisms by which it sets interest rates.
The ECB sets three key policy rates: the marginal lending facility rate, for overnight lending; the main refinancing operations rate, for weekly lending; and the deposit facility rate which is applied to overnight deposits that banks hold at the ECB. These three rates form a “corridor” – the marginal lending facility rate is the ceiling, the deposit facility rate is the floor, with the main refinancing operations rate in the middle. The short-term interest rate (also called the operational target) fluctuates within this corridor, depending on the amount of deposits, or reserves, that commercial banks have.
The operational framework revision relates to how these three key rates are set, which part of the corridor the operational target is steered to, what volume of reserves the ECB provides, and through which mechanisms it does so. This sounds like a complex, technical topic and to some extent it is. But it has far-reaching implications for the conduct of monetary policy in the euro area in the next few years and beyond. Therefore, it is important to understand and unpack the ECB’s recent decision.
As central banks conducted unconventional monetary policies in the aftermath of the global financial crisis, like asset purchases or (targeted) longer-term refinancing operations (LTROs and TLTROs), banks became flooded with reserves. As a consequence, the operational target moved towards the floor of the rate corridor. Once inflation started rising, central banks aimed to “normalise” by winding down the size of their balance sheet, or quantitative tightening.
This normalisation process has prompted central banks to reassess their operational frameworks, leading to two distinct approaches. On the one hand, the Bank of England (BoE) has opted for a “demand-driven” system. This means the BoE sets the rate of the lending facility – the short-term repo facility – from which banks will borrow. It is demand driven, meaning that banks will decide the volume of reserves and consequently the size of the BoE’s balance sheet.
On the other hand, the Federal Reserve has decided to go for a “supply-driven” system with an ample balance sheet. In this system, it is the Fed that decides the amount of reserves, which will be ample enough to keep the operational target at the floor of the corridor.
ECB approach has positive aspects and shortcomings
The ECB’s decision is a mix between the Fed and the BoE. On the one hand, the ECB will provide a share of reserves through structural operations – structural longer-term refinancing operations and a structural portfolio of securities. This share of reserves will be determined by the ECB, covering a portion of banks’ liquidity needs.
However, the other part of banks’ demands for reserves will be covered through one-week loans and three-month loans. As such, these demands will decide the amount of reserves provided through these loans. Therefore, the ECB’s operational framework will stand in the middle between a supply-driven and a demand-driven system.
We think there are positive elements to the ECB’s revision. The ECB will give consideration to its secondary mandate in supporting the EU’s wider economic objectives – especially its role in the green transition – within the operational framework. As a result, the ECB will incorporate climate change-related considerations into its structural operations.
While details are not yet disclosed, with a proper design this will be a very welcome addition to the ECB’s toolbox. In order for the design of these tools to effectively support the green transition, we suggest the structural operations should provide liquidity through green-targeted lending operations, as well as through the purchase of green and supranational bonds.
That said, there are some shortcomings to the ECB’s new approach.
First is the speed. The provision of liquidity through these structural operations will not come about until the current balance sheet is wound down, around 2026.
Second, is its firepower. The ECB will aim to keep the balance sheet, in the words of Isabel Schnabel, ”as lean as possible”. This means the volume of liquidity provision that the ECB will be able to do through these facilities will be rather small, especially if we compare it with previous asset purchase programmes or any of the TLTROs.
Finally, the ECB has decided not to change the minimum reserves banks need to hold. Given the windfall profits that banks have received as a by-product of recent monetary tightening, we believe the ECB’s operational framework should be ready to flexibly change reserve remuneration schemes. The current situation in which banks profit from a context of monetary austerity can and should be avoided.