Quarterly consumer credit flows expressed as a multiple of pre-pandemic average flows (Source: ECB; FRED; BoE)
The key message
Does President Lagarde have an easier job than Chair Powell or Governor Bailey? In one important respect, yes.
Demand for consumer credit remains very subdued in the euro area (EA) in absolute terms and in contrast to trends observed in the US and the UK.
The European Central Bank (ECB), Federal Reserve and Bank of England each face delicate balancing acts between reducing inflation (their core mandates) and weaker growth. On the one hand, higher interest rates are supposed to deter borrowing and hence reduce aggregate demand and inflation. On the other hand, increased borrowing is one way that households can offset the pressures of falling real incomes.
“Higher interest rates provide incentives to households to save more now and postpone consumption from the present to the future”
Philip Lane, October 2022
In terms of reducing inflation, the fact that demand for consumer credit remains very subdued in absolute terms and in contrast to trends observed in the US and the UK makes President Lagarde’s task easier (if not easy!).
The EA has experienced eight consecutive quarters of positive consumer credit flows since 2Q21 (see key chart). These flows have yet to recover to their pre-pandemic levels, however. In 1Q23, the quarterly flow totalled €4.1bn, down from €5.2bn and €4.9bn in 4Q22 and 3Q22 respectively. Perhaps more importantly, the 1Q23 flow was only 0.4x the pre-pandemic average quarterly flow of €10.2bn.
Investors positioned for growth in the EA might take some comfort from the recovery in consumer demand in March 2023. The monthly flow rose to €2.6bn from €1.6bn in February 2023, but was still only 0.76x the pre-pandemic average flow of €3.4bn.
That said, the relatively subdued nature of EA consumer credit demand suggests that the risks to the ECB’s balancing act lie more towards weaker growth/recession. A different balance of risks to those faced by Chair Powell and Governor Bailey.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
Exposure to NFC lending (% total loans) plotted against exposure to HH deposit funding (% total deposits) (Source: ECB; CMMP)
The key message
The impact of ECB monetary policy differs at the country and bank segment levels creating relative winners and losers among banks, savers and borrowers in the process
The transmission mechanism of policy has operated largely as expected but with three striking features – the scale and pace of the policy response, the speed of the pass through to the costs of NFC borrowing, and the limited pass through to the cost of HH overnight deposits.
Current aggregate dynamics are more positive for banking sectors with relatively high exposures to retail funding and NFC lending – the Italian and Spanish banking sectors. They are less positive for banking sectors with relatively low exposures to HH funding and NFC lending – the Netherlands (see key chart above).
Important differences exist between the funding mixes of the Spanish, German and Italian banking sectors (relatively high exposures to HH deposits) and the Dutch and French banking sectors (relatively high exposures to NFC funding). Spanish banks enjoy relatively high exposures to HH ON deposit funding. They have also experienced a below average pass through to the cost of these deposits.
In contrast, French banks have higher than average funding exposures to NFC and HH deposits with agreed maturities (part of M2-M1) and have experienced relatively rapid increases in the cost of these deposits.
Turning to the other side of banks’ balance sheets, Italian, French and Spanish banks benefit from above average exposures to NFC lending. They have also experienced above average increases in NFC lending rates. Spanish banks have experienced above average increases in mortgage rates too.
Spanish dynamics dominate much of this analysis. Recent trends have been negative for Spanish borrowers and savers, but positive for Spanish banks. Spanish borrowers face above average increases in their cost of borrowing, while savers see below average increases in deposit rates. Spanish banks, in contrast, not only benefit from these trends, but they also enjoy business mixes skewed towards lending to NFCs and borrowing from HHs.
The market may not have responded well to Banco Santander’s results yesterday (the share price fell by almost 6%). But the fact that the 46% YoY increase in domestic net interest income was lost in the noise, may not have been a bad thing, at least from a PR perspective…!
The winners and losers from ECB hiking
This final post in the “Passing Through” series examines how the transmission mechanism of ECB monetary policy differs at both the country and bank segment levels and explores why these differences matter. The analysis focuses on the EA’s five largest banking markets – Germany, France, Spain, Italy and the Netherlands. Even in this small sample, the differences are real and meaningful.
Changes in EA policy, market, wholesale and retail rates (ppt) between June 2022 and February 2023 (Source: ECB; CMMP)
The transmission of ECB monetary policy in the current hiking phase has largely followed theory (see chart above). There was a rapid pass through from the policy rate (300bp) to the market rate (288bp). From here the pass through to the cost of borrowing, while incomplete, was more rapid for corporate loans (202bp) than for HH loans (127bp). Similarly, in terms of funding costs, wholesale funding reflected changes in policy rates faster than retail deposits. The key differences between the current cycle and previous cycles are the relatively rapid pass through to NFC lending rates and the relatively slow pass thought to the cost of retail deposits in the current cycle.
Exposure to NFC lending (% total loans) plotted against exposure to HH deposit funding (% total deposits) (Source: ECB; CMMP)
These high-level sector dynamics are positive for banking sectors with relatively high exposures to retail funding and NFC lending (see chart above). Among the largest EA banking sectors, Italian and Spanish banks enjoy above average exposures to both HH deposit funding (63% and 61% of total deposits respectively) and NFC lending (43% and 40% of total lending respectively). In contrast, banks in the Netherlands have relatively low exposures to HH funding (46% total deposits) and NFC lending (32% total lending).
Note the contrast (see chart above) between the Spanish, German and Italian banking sectors (with relatively high exposures to HH deposits) and the Dutch and French banking sectors (with relatively high exposures to NFC funding). Note also that overnight (ON) deposits represent a relatively large percentage of HH and total deposits in the case of Spanish banks (see chart below).
HH deposits as %age of total deposits by country (Source: ECB; CMMP)
The positive news for Spanish banks does not end though. Not only do they enjoy relatively high funding exposures to HH ON deposits, but they have also seen a below average pass through to the cost of these deposits (see chart below).
HH ON deposits: Pass through plotted against % total deposits (Source: ECB; CMMP)
HH ON deposits represent 57% of total deposits in Spain compared with an average of 35% for EA banks. The pass through to Spanish ON deposits has been only 6bp compared with a EA average of 12bp. Note that while Italian and German banks also enjoy relatively high exposures to HH ON deposit funding, they have also seen above average (but still limited) pass through to the cost of these deposits (16bp and 14bp respectively).
NFC AGR deposits: Pass through plotted against % total deposits (Source: ECB; CMMP)
In contrast, French banks have higher than average funding exposures to NFC and HH deposits with agreed maturity (part of M2-M1) and have experienced relatively rapid pass throughs to the cost of these deposits. NFC deposits with agreed maturity represent 8% of French banks deposits compared with an EA average of 4% (see chart above). The cost of these deposits has risen 2.62ppt since June 2002, versus and average EA rise of 2.41ppt. (Note in passing the relatively low pass through to Spanish bank deposits here).
HH AGR deposits: Pass through plotted against % total deposits (Source: ECB; CMMP)
HH deposits with agreed maturity represent 12% of total French bank deposits compared with an EA average of 8% (see chart below). Again, the increase in the cost of these deposits in France (2.14ppt) have been higher than the EA average (1.63ppt).
NFC loans: Pass through plotted against % total loans (Source: ECB; CMMP)
The good news for the Italian, French and Spanish banking sectors is that they have (slightly) above average exposures to NFC lending and have experienced above average increases in NFC lending rates. NFC loans account for 43%, 41% and 40% of total loans in Italy, France and Spain respectively compared with an EA average of 39% (see chart above). The lowest exposure in this sample is in the Netherlands (32% total loans). The increase in the composite cost of borrowing has been highest in Spain (2.34ppt), then France (2.10ppt) and then Italy (2.02ppt). These compares with an average EA increase of 2.02ppt.
HH mortgages: Pass through plotted against % total loans (Source: ECB; CMMP)
Spanish banks have also experienced an above average increase in the mortgage lending rates (see chart above). These have increased by 2.34ppt since June 2022 compared with an average rise of 1.27pp across the EA.
Changes in EA and Spanish policy, market, wholesale and retail rates (ppt) between June 2022 and February 2023 (Source: ECB; CMMP)
This analysis illustrates how the impact of the transmission mechanism of ECB monetary mechanism varies considerably at both the country and bank segment levels.
The stand out theme here is the impact in Spain. Recent trends have been negative for Spanish borrowers and savers, but positive for Spanish banks. Spanish borrowers face above average increases in their cost of borrowing, while savers see below average increases in deposit rates. Spanish banks, in contrast, not only benefit from these trends, but they also enjoy business mixes skewed towards lending to NFCs and borrowing from HHs.
The market may not have responded well to Banco Santander’s results yesterday (the share price fell by almost 6%). But the fact that the 46% YoY increase in domestic net interest income was lost in the noise, may not have been a bad thing from a PR perspective…!
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
Changes in policy rates (ppt) by month from start of hiking cycle (Source: ECB; CMMP)
The key message
Euro area (EA) policy makers face very specific challenges arising from the unique features of the current hiking cycle.
The current ECB hiking cycle has three defining features. First, the scale and pace of the policy response makes this the most aggressive hiking cycle in ECB history. Second, the pass through from higher policy rates to the cost of overnight (ON) deposits has been very slow/limited. Third, and in contrast, the pass through to the cost of borrowing for EA corporates (NFC), while still incomplete, has been very rapid.
So what?
The first difference raises the risks of policy errors significantly. Policy makers may have plenty of “textbooks” available, but they may not have the correct “playbook” for a response of this magnitude.
In theory, the second difference limits the effectiveness of ECB policy to increase household (HH) saving and reduce consumption. In practice, however, this is much less of a challenge. EA HHs are already/still saving more and borrowing less to support consumption than they did pre-COVID. Recall the contrast here with both the US and UK experience.
The third difference raises the balance of “growth risks” strongly to the downside. The 202bp increase in the composite cost of NFC borrowing since June 2022 is almost equal to the 212bp increase experienced in the entire 32-month, 2005-08 hiking period. On top of this, banks have been tightening lending standards. This matters because (1) bank finance makes up the bulk of debt financing for EA NFCs and (2) the EA needs more, not less, productive COCO-based lending (and less unproductive FIRE-based lending).
The very real differences that exist in the transmission mechanism at the country and bank levels across the EA level complicate these challenges further – the subject of the final post in this series.
Passing Through IV
This series of posts, (“Passing Through II” – “Passing Through IV”) analyses the Bank Lending Channel (BLC) and its role in the transmission mechanism of ECB monetary policy. They focus on:
What is the BLC and how does it work?
How does the current cycle compare with the previous 2005-08 cycle?
What are the key challenges for policy markets, bankers and investors?
This penultimate post focuses on the third question and specifically on the key challenges for policy makers relating to:
The scale and pace of the policy response
The very slow/limited pass through from higher policy rates to the cost of overnight deposits
The rapid pass though from higher policy rates to the cost of NFC borrowing
The key challenges for policy makers
The scale and pace of the policy response
The current hiking cycle is the most aggressive in ECB history – a 350bp increase in the policy rate in only nine months compared with a 225bp increase over 32 months in the 2005-08 hiking cycle (see chart below).
“Monetary policy is always decided under conditions of uncertainty”
Philip Lane, 11 October 2022
Not only is the pace and scale of the current policy unique but the ramifications are far from certain given the long, variable and uncertain time lags that characterise the transmission mechanism. The belated nature of the policy response also suggests a greater risk that rates go higher and stay higher for longer than would otherwise be the case.
Changes in policy rates (ppt) by month from start of hiking cycle (Source: ECB; CMMP)
This suggests that the risks of policy errors are greater in this cycle than in previous cycles. Textbooks on the transmission mechanism of monetary policy and playbooks for the current, unique phase of monetary policy are not the same thing.
The limited pass through to the cost of overnight deposits
Changes in policy rates and cost of HH overnight deposits (ppt) by month from start of hiking cycle (Source: ECB; CMMP)
Higher interest rates provide incentives to households to save more and to postpone consumption. The challenge for the ECB so far, however, is that the pass through from policy rates to the cost of overnight deposits has been very slow/limited. The 300bp increase in the MRO rate between June 2022 and February 2023 has passed through to an increase of only 12bp in the cost of HH overnight deposits. As discussed in “Passing Through III”, EA banks are relatively liquid and flush with overnight deposits and have much less incentive to raise the rates offered on overnight deposits.
In theory, this very slow/limited pass through should limit the effectiveness of ECB policy. In practice, this is less of challenge for two reasons – (1) HHs are still saving more than they did pre-COVID, and (2) demand for consumer credit remains very subdued.
Between 4Q02 and 4Q19, the HH savings ratio averaged 13% of gross disposable income. During the pandemic, this rose to 21% in 3Q21, a combination of forced and precautionary savings. At the end of 4Q22, the savings ratio had fallen back to 14% but remained at the higher end of “pre-pandemic norms”.
A key theme from the messages from the EA money sector has been the consistently subdued demand for consumer credit. The 3m MVA flow fell to €1.1bn in February 2023, down from €1.2bn in January 2023, and only 0.3x the pre-pandemic average flow (see chart above). Consumer credit flows have failed to recover to their pre-pandemic levels, in contrast to trends observed in both the US and the UK. The risks to the ECB’s balancing act already lie more towards weaker growth/recession.
The rapid pass through to the cost of borrowing for NFCs
“The tightening of financing conditions and stricter credit standards are expected to weigh more strongly on (both residential) and business investment over the coming quarters.”
Philip Lane, April 2023
Changes in market rates and NFC COB (ppt) by month from start of hiking cycle (Source: ECB; CMMP
The 300bp and 288bp increase in policy and market rates between June 2022 and February 2023 has passed through to a 202bp increase in the NFC composite cost of borrowing (CCOB). Note that this pass though is almost equal to the pass though of 212bp experienced in the entire 32-month, previous cycle.
This is important for two reasons. First, bank-based finance makes up the bulk of debt financing for EA corporates. Second, the EA needs more, not less, productive COCO-based lending and less unproductive FIRE-based lending.
Unfortunately, the pass through is more rapid to the former than to the latter, with adverse, if unintended consequences for lending dynamics going forwards. To compound these trends EA banks have been reporting a tightening of credit standards throughout 2022. Lower loan volumes typically follow such tightening several quarters later.
Conclusion
The most aggressive hiking series in ECB history brings unique challenges for which there is no specific playbook. The risks of policy errors are significant and the risks to economic growth skewed clearly to the downside. The euro area relies heavily on bank finance and the region needs more, not less, productive lending and investment.
The very real differences that exist in the transmission mechanism at the country and bank levels complicate these challenges further – the subject of the final post in this series.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
How does the current hiking cycle compare with 2005-2008?
The key chart
Comparison of changes in EA policy, market, wholesale and retail rates (ppt) during current and previous hiking cycles (Source: ECB; CMMP)
The key message
The Bank Lending Channel (BLC) is an important element of the transmission mechanism of ECB monetary policy. It is working largely as expected during the current hiking cycle through bank funding costs and the “interest rate channel.” There are important differences however between this cycle and the previous, November 2005-July 2008 cycle.
The most striking difference between the two cycles is the scale and pace of the policy responses.
The current (belated) hiking cycle is the most aggressive in ECB history – a 350bp increase in the policy rate in only nine months, compared to an increase of 225bp over 32 months in the earlier cycle. Lenders and borrowers have had limited time to adjust. It will also take time before the full impact and effectiveness of current policy becomes clear. In the meantime, the message from the EA’s money sector is that the ECB is tightening aggressively into an already slowing economy.
The second striking difference is the very slow/limited pass through to the cost of overnight (ON) deposits (the largest portion of bank ST liabilities) in the current cycle.
The reason? Very different liquidity positions and funding mixes at the start of each cycle – loans to deposit ratios of 116% in November 2005 versus 85% in July 2022, and ON deposits to total deposits of 34% in November 2005 versus 54% in July 2022. In short, there was (and still is) little incentive for liquid banks that are still flush with overnight deposits from the COVID-periods to raise ON deposit rates quickly in the current environment. Negative news for savers and the ECB alike.
Note that there has been a more rapid pass through in the cost of new deposits with an agreed maturity (part of M2-M1). This is important context for understanding recent trends in monetary aggregates.
EA banks have experienced outflows of ST liabilities (M3) in four of the past five months. This reflects six consecutive months of overnight deposit outflows (M1). Substitution effects/inflows into better-remunerated ST deposits, and into marketable securities (M3-M2) have not been enough to compensate. They also come at a higher cost.
The third striking difference is in the pace of pass through to NFC lending rates.
The 202bp increase here in the past eight months is not only sudden, but it also almost matches the full 212bp pass through experienced over the full 32-month cycle in 2005-08. This matters because the EA needs more, not less, productive COCO-based lending and less unproductive FIRE-based lending. Unfortunately, the pass though is more rapid to the cost of former than to the cost of the latter, creating a negative incentive for productive investment. This and other important consequences are the subject of the next post.
Passing Through III
This series of three posts (“Passing Through II – Passing Through IV”) analyses the BLC and its role in the transmission mechanism of ECB monetary policy. They focus on three questions:
What is the BLC and how does it work?
How does the current hiking cycle compare with the previous 2005-08 cycle?
What are the key challenges for policy makers, bankers and investors?
How does the current hiking cycle compare with the previous 2005-08 cycle?
Changes in policy rates (ppt) by month from start of hiking cycle (Source: ECB; CMMP)
The current (belated) hiking cycle is the most aggressive in the ECB’s history in terms of both scale and pace. The policy rate (MRO) rose 350bp in the nine months between the 27 June 2022 and 22 March 2023. During the previous hiking cycle between November 2005 and July 2008, the policy rate rose only 225bp over a more extended 32-month period (see chart above).
Lenders and borrowers have had little time to adjust to this paradigm shift from the ECB – an aggressive, if belated policy response. Given the long, variable and uncertain time lags that characterises the transmission mechanism of monetary policy, it will take some time before the effectiveness and impact of the current policy becomes clear.
The message from the EA money sector is clearer, however. The ECB is tightening policy aggressively into an already slowing economy.
Changes in policy and market rates (ppt) by month from start of hiking cycle (Source: ECB; CMMP)
The pass through from policy rates to rates to market rates has been rapid, if incomplete. The 350bp increase in the MRO has passed through to a 315bp increase in 3m EURIBOR. In the 2005-2008 hiking cycle, the 225bp increase in the MRO passed through to a 260bp increase in 3m EURIBOR (see chart above). Please note that in this case, changes in policy rates in March 2023 are included. For the rest of the analysis below, the reference period ends in February 2023. Bank interest rate data is only available up to this point.
As discussed in “Passing Through II”, increases in market rates are transmitted via bank funding costs to lending rates for new loans via the interest rate channel (as well as by the repricing of outstanding variable rate loans).
Changes in policy and ON deposit rates (ppt) by month from start of hiking cycle (Source: ECB; CMMP)
A striking feature of the current, aggressive hiking cycle is the very limited pass through to the cost of bank overnight deposits (the largest portion of their ST liabilities). The 300bp increase in the MRO between June 2022 and February 2023 has passed through to increases of only 36bp and 12bp in the cost of NFC and HH overnight deposits respectively.
Changes in ON deposit rates (ppt) by month from start of hiking cycle (Source: ECB; CMMP)
The key point here is not that the pass through is incomplete – that is to be expected – but that it has been so limited. In the 2005-08 hiking cycle, the 225bp increase in the MRO passed thought to a 114bp and 56bp increase in the cost of NFC and HH overnight deposits. Interestingly, the pass of the pass through to the cost of overnight deposit has been broadly similar in both cycles (see chart above).
Trends in aggregate LDR (%) for EA banks (Source: ECB; CMMP)
Part of the explanation here lies in the different liquidity positions and funding mixes of EA banks at the start of each hiking cycle. At the start of the 2005 hiking cycle, the aggregate loans to deposit ratio for EA banks was 116%. At the end of this cycle in July 2008, it was 114%. In contrast, at the start of the current cycle, the aggregate loans to deposit ratio was only 85%, close to its recent low (see chart above).
Trends in share of ON deposits to total deposits (%) (Source: ECB; CMMP)
EA banks are also flush with overnight deposits, following the hoarding of cash by NFCs and HHs during the COVID-pandemic. At the start of the current hiking cycle, overnight deposits accounted for 54% of total deposits. This compares with 34% in November 2005. The main point here is that EA banks have much less incentive to raise the rates offered on overnight deposits.
Changes in policy rates and rates on deposit with agreed maturities (ppt) by month from start of hiking cycle (Source: ECB; CMMP)
There has been a more rapid pass through to the costs of new deposits with an agreed maturity, particular for NFCs. The NFC CIR has risen 240bp already, slightly more than the 238bp that occurred in the more extended, previous cycle. The HH CIR has increased more slowly by 163bp, compared to 255bp in the previous cycle.
Note that, deposits with an agreed maturity accounted for only 4% of total deposits in June 2022 compared with 12% in November 2005. Reflecting the interest rate trends described here, they rose to 7% of total deposits at the end of February 2023.
Growth trends in EA broad money (% YoY) and contribution of components (Source: ECB; CMMP)
The interest rate dynamics described here provide important context for the recent trends in monetary aggregates in the EA (see “Still tightening as stresses mount”). Banks are experiencing net outflows of ST liabilities and a substitution away from low-cost overnight deposits to more expensive “other ST deposits” at the margin (see charts above and below).
Monthly flows (EUR bn) in broad money and key components (Source: ECB; CMMP)
As can be seen in the chart above, EA banks have experienced outflows of ST liabilities (M3) in four of the past five months. This reflects six consecutive months of overnight deposit outflows (the blue columns). Inflows in other ST deposits (within M2-M1) and, to a lesser extent, marketable securities (within M3-M2) have not been able to compensate. As noted above, they also come at a higher cost.
Changes in market rates and composite cost of borrowing indicators (ppt) by month from start of hiking cycle (Source: ECB; CMMP)
The pass through to lending rates has been more rapid, particularly in the case of the composite cost of borrowing (COB) for NFCs. The 300bp increases in policy rates has passed through to a 202bp increase in the NFC COB and a 127bp increase in the HH COB between June 2022 and February 2023 (see chart above).
Changes in composite cost of borrowing indicators (ppt) by month from start of hiking cycle (Source: ECB; CMMP)
Note that the pass through in the COB for NFCs (202bp) in the current eight-month cycle (so far) is almost equal to the pass though of 212bp experienced in the entire 32-month, previous cycle. This matters because the EA needs more not less productive COCO-based lending and less unproductive FIRE-based lending. Unfortunately, the pass though is more rapid to the former than to the latter, with adverse, if unintended, potential consequences for lending dynamics going forward. These and other consequences are the subject of the next post.
Conclusion
In this post, I have highlighted three key differences between the current policy response and the workings of the BLC in the current hiking cycle and the previous 2005-08 hiking cycle. These are: (1) the scale and pace of the policy response; (2) the speed of the pass through to overnight deposits; and (3) the speed of the pass though the cost of borrowing for NFCs in the EA. Context has also been provided to help understand recent developments in EA monetary aggregates better. The next post explores these and other consequences in more detail.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
What is the Bank Lending Channel and how does it work?
The key chart
Changes in EA policy, market, wholesale and retail rates (ppt) between June 2022 and February 2023 (Source: ECB; CMMP)
The key message
This is the first in a series of three posts analysing the Bank Lending Channel (BLC) and its role in the transmission of ECB monetary policy. The focus here is:
What is the BLC and how does it work?
The BLC is one of the “downstream effects” of the transmission mechanism that relate to changes in the cost and volume of bank financing for NFCs and HHs.
Its importance to the transmission of ECB monetary policy reflects the fact that the euro area (EA) is largely a “bank-centred” economic region (especially Italy, Germany and Spain).
They are two key elements to the BLC: (1) bank funding costs and (2) the “interest rate channel”. In terms of the former, theory and experience tells us that the marginal cost of wholesale funding typically reflects changes in policy rates relatively quickly. In contrast, retail deposit rates adjust more slowly, thereby containing the rise in bank funding costs during a period of higher interest rates. Clearly then, the funding mix plays an important role in determining the effectiveness of overall policy (see the second post in this series) and its impact at the country level (see the third post in this series).
Increases in market rates are transmitted via bank funding costs to lending rates for new bank loans via the interest rate channel (as well as by the repricing of outstanding variable rate loans). Banks typically apply a mark-up on top of their funding costs (c.190bp and 200bp for NFC and HH loans respectively). It is reasonable to expect a more rapid pass through of policy and market rates to the costs of NFC (market) debt, then NFC (bank) loans, then HH loans.
Practice has followed theory in the EA since June 2022.
There was a rapid pass though from the policy rate (300bp) to the market rate (288bp) between June 2022 and February 2023. The pass through to NFC and HH deposits with agreed maturity was incomplete but more rapid in the NFC sector (240bp) than in the HH sector (163bp).
The very limited pass through to the cost of overnight deposits is particularly noteworthy, both in terms of historic precedent (“Passing Through II”) and the implications for policy effectiveness (“Passing Through III”).
In terms of the interest rate channel, the pass though has been more rapid in the case of NFC loans than for HH loans but remains incomplete so far in both cases.
In short, the BLC is working in practice in the same was as theory would suggest through both bank funding costs and the interest rate channel. There are important differences, however, between current experiences and those of previous hiking cycles and important differences in the BLC at the country and sector levels that create challenges for policy makers, banks and investors alike. The next two posts address these issues in turn.
Passing Through II
This series of three posts (“Passing Through II – Passing Through IV”) analyses the BLC and its role in the transmission mechanism of ECB monetary policy. They focus on three questions:
What is the BLC and how does it work?
How do the current working of the BLC compare with previous hiking cycles?
What are the key challenges for policy makers, bankers and investors?
What is the BLC and how does it work?
The ECB likes to divide analysis of the monetary policy transmission process into two parts –upstream and downstream effects.
Upstream effects relate to how the steering of ST money market conditions affects risk-free rates and sovereign yield curves.
Downstream effects relate to how policy decisions affect the cost and volume of bank financing for NFCs and HHs.
The focus here is on one important downstream effect – the Bank Lending Channel – and its two key elements, namely funding costs and the interest rate channel.
Bank credit as a percentage of total private sector credit (Source: BIS; CMMP)
The importance of the BLC in the transmission of ECB monetary policy reflects the fact that the euro area (EA) is largely a “bank-centred” economic region (see chart above). Bank credit accounts for 55% of total private sector credit in the EA, compared with 46% for all advanced economies. Bank credit plays a particularly important role in Italy (65% total), Germany (65% total) and Spain (59% total), but less so in France (49% total) and the Netherlands (39% total).
Funding costs are the first key element of the BLC. The marginal cost of wholesale funding typically reflects changes in policy rates relatively quickly. In contrast, retail deposit rates adjust more slowly, thereby containing the rise in bank funding costs during a period of higher policy rates. Clearly then, the funding mix plays an important role in determining the effectiveness of overall policy and its impact at the country level.
The interest rate channel is the second key element of the BLC. Increases in market rates (eg 3m EURIBOR, or 12m EURIBOR in Spain) are transmitted via bank funding costs to bank lending rates for new loans via the interest rate channel, as well as by the repricing of the outstanding stock of variable rate loans. Banks typically apply a mark-up on top of their funding costs. Over the past twenty years, the mark up on the composite cost of borrowing indicator (CCOB) for NFCs and HHs (for home purchases) has been 193bp and 200bp respectively. Note that it is reasonable to expect a more rapid pass through of policy rates to the cost of NFC (market) debt, then NFC (bank) loans, then HH loans.
Changes in policy rates, market rates and selected bank funding costs (ppt) between June 2022 and February 2023 (Source: ECB; CMMP)
In terms of funding costs and the interest channel, practice has followed theory in the EA since June 2022.
The MRO (policy rate) and 3m EURIBOR (market rate) rose 300bp and 288bp between June 2022 and February 2023 (and further again in March). In other words, there was a rapid pass though from the policy rate to the market rate. The NFC and HH composite interest rates (CIR) for deposits with agreed maturity rose 240bp and 163bp over the same period. As expected, the pass through to wholesale deposits has been more rapid than to retail deposits.
That said, the limited pass through to the cost of overnight deposits is noteworthy both in terms of historic precedent (the subject of Passing Through III) and the implications for policy effectiveness (the subject of “Passing Through IV”).
Trends in market rates and the NFC and HH composite cost of borrowing indicators (%) (Source: ECB; CMMP)
In terms of the interest rate channel, the so-called “pass through” has been more rapid in the case of NFC loans than for HH loans (see chart above). The NFC CCOB has increased 202bp since June 2022, to 3.85%. The HH CCOB for house purchase has increased by 127b to 3.24% over the same period (see chart below).
Changes in policy rates, market rates and NFC and HH composite cost of borrowing indicators (ppt) between June 2022 and February 2023 (Source: ECB; CMMP)
Note that in both cases, the lagged effect of pass through to lending rates so far, means that the spread over 3m EURIBOR has narrowed sharply to 121bp and 60bp respectively. This is not unusual (see chart below).
Spread between NFC and HH CCOB and 3m EURIBOR (ppt) (Source: ECB; CMMP)
Another way of thinking about this, however, is that is the full average mark up over the past twenty years was applied to the 3m EURIBOR rate in February 2022, the NFC CCOB would rise from 3.85% to 4.57% and the HH CCOB would rise from 3.24% to 4.64%.
Conclusion
The BLC is working in practice in the same was as theory would suggest through both bank funding costs and the interest rate channel. There are important differences, however, between current experiences and those of previous hiking cycles and important differences in the BLC at the country and sector levels that create challenges for policy makers, banks and investors alike. The next two posts address these issues in turn.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
Monthly consumer credit flows as a multiple (x) of pre-pandemic average flows (Source: FRED; BoE; CMMP)
The key message
The messages from the US, UK and euro area (EA) money sectors are converging around a common theme – downside risks to household (HH) consumption and economic growth.
The consumer credit dynamics behind these messages remain very different, however – sharply slowing demand in the US, surprisingly resilient demand in the UK, and consistently subdued demand in the EA (see key chart above).
The Federal Reserve, Bank of England (BoE) and European Central Bank (ECB) face delicate balancing acts between reducing inflation (their core mandates) and weaker growth. Higher interest rates are supposed to deter borrowing and hence reduce aggregate demand and inflation. At the same time, increased borrowing is one way that households (HHs) can offset the pressures of falling real incomes. How is this playing out so far, in 1Q23?
Demand for consumer credit remains slightly above pre-pandemic levels in both the US and the UK suggesting that risks towards more persistent inflation remain. The very rapid pace of adjustment in US consumer credit demand complicates matters, however, and suggests that Chair Powell may have a more challenging task here than Governor Bailey. In contrast, consistently subdued EA consumer credit demand suggest that the risks to the ECB’s balancing act lie more towards weaker growth/recession. An altogether different challenge for President Lagarde, the subject of my next post…
Clues from consumer credit III
Monthly consumer credit flows tell us a great deal about the relative strength of the US, UK and EA economies and the risks associated with growth. The immediate response of HHs in the US, UK and EA was consistent – they all repaid consumer credit. The subsequent responses were anything but consistent, however (for background see “Clues from consumer credit”, November 2022).
US dynamics
Trends in US monthly consumer credit flows ($bn) (Source: FRED; CMMP)
Between March 2022 and December 2022, monthly flows of US consumer credit were more than double their pre-pandemic average. Back in November 2022, I suggested that the risks to the US growth outlook lay in the sustainability of these flows in the face of rising borrowing costs. In the first two months of 2023, these flows slowed sharply to 1.6x and 1.1x pre-pandemic averages (see chart above). In short, demand for consumer credit is moderating sharply rather than collapsing, at least so far.
UK dynamics
Trends in UK monthly consumer credit flows (£bn) (Source: BoE; CMMP)
UK demand for consumer credit has been surprisingly resilient. Over the past twelve months, monthly flows have remained close to their pre-pandemic average level of £1.2bn. The 3m MVA of monthly flows was 1.1x the pre-pandemic average in both January and February 2023, up from 0.7x in October 2022 (see chart above).
EA dynamics
Trends in EA monthly consumer credit flows (EURbn) (Source: ECB; CMMP)
The theme in the EA has been one of consistently subdued demand for consumer credit. The 3m MVA flow fell to €1.1bn in February 2023, down from €1.2bn in January, only 0.3x the pre-pandemic average flow (see chart above). The key message in the EA has been that consumer credit flows have failed to recover to their pre-pandemic levels, in contrast to trends observed in both the US and the UK.
Conclusion
The Federal Reserve, Bank of England (BoE) and the European Central Bank (ECB) face delicate balancing acts between reducing inflation (their core mandates) and weaker growth. Higher interest rates are supposed to deter borrowing and hence reduce aggregate demand and inflation. At the same time, increased borrowing is one way that households (HHs) can offset the pressures of falling real incomes. How is this playing out in 1Q23?
Demand for consumer credit remains slightly above pre-pandemic levels in both the US and the UK suggesting that risks towards more persistent inflation remain. The very rapid pace of adjustment in US consumer credit demand complicates matters, however, and suggests that Chair Powell may have a more challenging task here than Governor Bailey. In contrast, consistently subdued EA consumer credit demand suggest that the risks to the ECB’s balancing act lie more towards weaker growth/recession. An altogether different challenge for President Lagarde…
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
Trends in policy rate and composite cost of mortgage borrowing (Source: ECB; CMMP)
The key message
What do recent trends in the cost of euro area (EA) mortgages tell us about the transmission mechanism of ECB monetary policy?
Current ECB monetary policy is notable for both the speed and the scale of the (belated) response. Policy rates have risen 350bp since 27 July 2022, faster than in previous cycles. The speed of the transmission mechanism on the cost of new mortgages – 127bp over the same period – has been equally notable; exceeding the 123bp rise recorded over 32 months between December 2005 and July 2008. Banks and borrowers have had little time to adjust.
The speed of transmission has varied widely, however, even among the EA’s five largest mortgage markets. The cost of borrowing has increased by 174bp and 161bp in Spain and Italy respectively, for example, but by only 100bp in France.
The speed of the transmission mechanism on the cost of new mortgages bears little relationship with either the structure of loans (e.g. variable rate versus fixed rate) or the cost of borrowing at the start of the period. This suggests that country- and industry-specific factors e.g. the level of competition or central bank restrictions (as in the case of France) may be more important, in the short term.
There is a much closer relationship, however, between the speed of the transmission mechanism on the cost of borrowing on the outstanding stock of mortgages and loan characteristics. Some of the largest increases here have occurred in Estonia, Lithuania, Latvia and Finland – markets where the share of variable rate loans exceed 90% – while some of the smallest increases have occurred in the Netherlands, Germany and France – markets where the share is less than 25%.
In Spain, the EA’s fourth largest mortgage market, the share of variable rate mortgages has fallen from over 90% to 25%, in-line with the EA average. Despite this, the cost of borrowing for new and outstanding mortgages has risen faster than the EA average during the current hiking phase. This has led to political pressure domestically and questions for the ECB. The minority party in the coalition government is calling for a cap on the rates on variable loans, while the ECB considers this a matter between the banks and borrowers. Either way, seven consecutive months of net repayments since August 2022 and two consecutive months of negative YoY growth rates may be more significant.
In short, the transmission of monetary policy rates to mortgage rates (the largest segment of EA private sector credit) is both rapid and variable. Banks and borrowers have had little time to adjust to the scale and pace of current tightening. Country-and industry-specific factors are key in determining the speed of transmission on new lending. Loan characteristics are key in determining the speed of transmission on outstanding mortgages and banks’ net interest margins.
Passing through!
The current ECB policy response
Current ECB monetary policy is notable for both the speed and the scale of the (belated) response. Policy rates have risen 350bp in the space of only eight months. For context, in the last sustained period of monetary tightening between 6 December 2005 and 9 July 2008, the policy rate rose 225bp in the space of 32 months (see chart below).
Trends in ECB policy rate (%) (Source: ECB; CMMP)
The transmission mechanism – the background
The transmission mechanism of ECB monetary policy – the process through which monetary policy decisions affect the EA’s economies in general and the price level in particular – is characterised typically by long, variable and uncertain time lags. This makes predicting the precise effect of policy decisions difficult. Two factors to note:
Changes in the ECB’s monetary stance typically affect lending rates for new loans quickly (see below). However, more time may be needed to impact lending rates for banks outstanding loan portfolios.
Different loan characteristics also have a substantial impact on the speed of the transmission mechanism at the country level. These include the type of loans (variable rate versus fixed rate), the frequency of revision rates and loan maturities.
Share of variable rate mortgages (% total mortgages) over past 20 years (Source: ECB; CMMP)
There has been a shift away from variable rate mortgages since the GFC, which has only be reversed relatively recently (see chart above). Variable rate mortgages accounted for 59% of total mortgage in November 2004. This share fell to only 13% in January 2017 and stayed around this level until March last year. Since then, there has been a shift back towards variable rate mortgages. This peaked at 25% in December 2023, however, before falling back slightly to 24% in February 2024.
Loan characteristics by country (February 2023) (Source: ECB; CMMP)
As always, aggregate EA figures mask very different market structures across the EA. The share of variable rate mortgages in total new mortgages ranges from over 90% in Finland, Lithuania, Estonia and Latvia to only 4% in France, for example. Within the five EA economies that account for 85% of the region’s mortgages, this range extends from 46% in Italy to 4% in France.
Note that changes in ST rates typically have a great impact on net interest margins in countries and sectors that are characterised by floating rate lending.
The transmission mechanism in practice
Trends in policy rate and composite cost of mortgage borrowing (Source: ECB; CMMP)
Recent policy has had an immediate impact, especially (as expected) on the cost on new mortgages. The chart above illustrates trends in the policy rate (MRR) and the interest rate on new mortgage loans and outstanding mortgage loans with a maturity over five years. As can be seen, the rate on new mortgage loans (the blue line) reacts much faster than the rate on outstanding mortgage loans (the maroon line) to changes in the policy rate (the black line).
At the aggregate EA level, the cost of new mortgages has increase 127bp from 1.97% to 3.24%. This is a bigger increase than the 123bp recorded in the previous hiking cycle between December 2005 and July 2008. The cost of outstanding mortgages has increased 41bp, from 1.63% to 2.04%.
Change in CCOB (in ppt) since June 2022 (Source: ECB; CMMP)
The composite cost of new mortgages has risen 127bp since June 2022, from 1.97% to 3.24%. At the country level, the rise in the CCOB indicator has ranged widely from over 200bp in Estonia (276bp), Lithuania (275bn), Latvia (247bp), Slovakia (211bp) and Portugal (206bp) to less than 100bp in Greece (76bp), Ireland (25bp) and Malta (25bp). Among the largest five EA mortgage markets, the change has ranged from 174bp and 161bp in Spain and Italy respectively to only 119bp and 100bp in Germany and France respectively (see chart above).
Composite cost of new mortgages (%) as at end February 2023 (Source: ECB; CMMP)
The cost of new mortgages also varies widely between the five largest mortgage markets. The range extends from 3.79% and 3.76% in Italy and Germany respectively to only 2.35% in France (see chart above). France has the lowest composite cost of borrowing in the EA. Note that in addition to their relatively high exposure to fixed rate mortgages, French banks are also constrained by a limit, set by the Banque de France, on the amount they can charge for mortgages.
The speed of transmission
Change in CCOB for new mortgages plotted against loan characteristic (Source: ECB; CMMP)
The speed of the transmission mechanism on the cost of new mortgages bears little relationship with either the structure of loans (see chart above) or the cost of borrowing at the start of the period (see chart below). This suggests that country- and industry-specific factors (eg, the level of competition) may be more important, in the short term.
Change in CCOB for new mortgages plotted against CCOB in June 2022 (Source: ECB; CMMP)
There is a much closer relationship, however, between the speed of the transmission mechanism on the cost of borrowing on the outstanding stock of mortgages and loan characteristics (see chart below). These characteristics include not only the loan structure but also the frequency of revision rates and loan maturities.
Change in CCOB for outstanding mortgages plotted against loan characteristic (Source: ECB; CMMP)
In this case, some of the largest increases have occurred in Estonia, Lithuania, Latvia and Finland – markets where the share of variable rate loans exceed 90% – while some of the smallest increases have occurred in the Netherlands, Germany and France – markets where the share of variable loans is less than 25%.
What is happening in Spain?
Trends in EA and Spanish loan characteristics over past twenty years (Source: ECB; CMMP)
Spain is the EA’s fourth largest mortgage market after Germany, France and the Netherlands. The share of variable loans in Spain has fallen from over 90% (pre- and during the GFC) to 25%, in-line with the EA average.
Monthly trends in CCOB for new mortgages in EA and Spain (%) (Source: ECB; CMMP)
Despite this, the cost of borrowing for new and outstanding mortgages has risen faster than the EA average during the current hiking phase. Between June 2022 and February 2023, the cost of new mortgages in Spain increased 174bp from a below EA average 1.69% to an above EA average of 3.43% (see chart above).
Trends in ECB policy rate and composite cost of outstanding Spanish mortgage borrowing (Source: ECB; CMMP)
More importantly for domestic Spanish banks, the rates on outstanding mortgages have risen 129bp since June 2022, from a below EA average of 1.23% to an above EA average of 2.38% (see chart above).This has led to political pressure domestically and on the ECB. The minority party in the coalition government is calling for a cap on the rates on variable loans, for example.
“I’m sure that banks are ready to negotiate in order to ease the burden on households over time. It is in the banks’ interest to do so.”
ECB President Lagarde, 5 March 2023
In a 5 March 2023 interview with “El Correo”, ECB President Lagarde was asked: (1) if she had a comment for Spanish families suffering from higher rates; (2) if she thought that caps were feasible; and (3) whether Spanish banks should remunerate customer deposits. Perhaps unsurprisingly, Madame Lagarde, argued that these issues were determined by the relationship between borrowers and lenders.
In this context, a more telling response comes from industry dynamics instead. Spain has experienced seven consecutive months of net repayments since August 2022 (see chart above) and two consecutive months of negative YoY growth rates (see graph below).
Trends in annual growth rates in mortgages for EA’s five largest markets (Source: ECB; CMMP)
Conclusion
The transmission of monetary policy rates to mortgage rates (the largest segment of EA private sector credit) is both rapid and variable. Banks and borrowers have had little time to adjust to the scale and pace of current tightening. Country-and industry-specific factors are key in determining the speed of transmission on new lending. Loan characteristics are key in determining the speed of transmission on outstanding mortgages and banks’ net interest margins.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
The BoE and ECB face different challenges from divergent consumer credit trends
The key chart
UK and EA consumer credit flows expressed as a multiple of pre-pandemic average flows (Source: BoE; ECB; CMMP)
The key message
The Bank of England (BoE) and the ECB face different balancing acts. Both have achieved success in deflating their respective mortgage markets and slowing growth in less-productive FIRE-based lending. Divergent trends in consumer credit demand point to different challenges, however, in terms of balancing household (HH) consumption and inflation (BoE) and HH consumption and growth (ECB).
Increased borrowing is one way that HHs can offset the pressures of falling real incomes. Monthly consumer credit flows in the UK dipped slightly in February 2023 from January’s recent high, but remain 1.2x their pre-pandemic level. In contrast, monthly consumer credit flows in the EA remain well below (0.6x) their respective pre-pandemic level.
Higher interest rates are supposed to deter borrowing and hence reduce aggregate demand and inflation. Resilient UK consumer credit demand suggests that the risks to the BoE’s balancing act lie towards inflation that is more persistent. In contrast, subdued EA consumer credit demand suggests that the risks to the ECB’s balancing act lie towards weaker growth/recession. Neither are easy to manage…
Different balancing acts – the details
UK consumer credit flows
The monthly flow of UK consumer credit decreased to £1.4bn in February 2023, down from the recent high of £1.7bn in January 2023 but above December 2022’s monthly flow of £0.8bn. February’s monthly flow was 1.2x the pre-pandemic flow of £1.2bn. The 3m MVA of UK consumer credit flows remained at £1.3bn, 1.1x the pre-pandemic flow (see chart below).
Trends in UK monthly consumer credit flows (Source: BoE; CMMP)
EA consumer credit flows
The monthly flow of EA consumer credit rebounded to €1.9bn in February, but remained only 0.55x the pre-pandemic average flow of €3.4bn. The 3m MVA flow fell to €1.1bn, from €1.2bn in January, 0.33x the pre-pandemic average flow. They key point here is that, in contrast to trends observed in the UK (and the US), consumer credit flows have failed to recover to their pre-pandemic levels (see chart below).
Trends in EA monthly consumer credit flows (Source: ECB; CMMP)
Conclusion
Trends in consumer credit demand matter because increased borrowing is one way that UK and EA HHs can offset the pressures from falling disposable incomes (along with reduced savings). Consumer credit is also the second most important element of productive COCO-based lending, after corporate debt. It supports productive enterprise since it drives demand for goods and services, hence helping corporates to generate sales, profits and wages.
Higher interest rates are supposed to deter borrowing and hence reduce aggregate demand. Resilient UK consumer credit demand suggests that the risks to the BoE’s balancing act lie towards inflation that is more persistent. In contrast, subdued EA consumer credit demand suggests that the risks to the ECB’s balancing act lie towards weaker growth/recession. Neither are easy…
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
The sound of deflating UK and EA mortgage markets is getting louder
The key chart
Monthly UK and EA mortgage flows expressed as a multiple of pre-pandemic average flows (Source: BoE; ECB; CMMP)
The key message
“Pschitt” – the sound of deflating UK and EA mortgage markets is getting louder.
Monthly mortgage flows have fallen well-below pre-pandemics levels in both regions (only 0.5x in the UK and 0.3x in the EA). Monthly flows have also recorded three and four consecutive months of below pre-pandemic average levels in the UK and EA respectively (on a 3m MVA basis). The rate of slowdown is particularly sharp in the EA. EA monthly flows have fallen from €25.9bn in June 2022 (2.1x pre-pandemic flows) to only €4.2bn in February 2023 (0.3x pre-pandemic flows).
These trends matter because mortgage demand typically displays a co-incident relationship with real GDP. In this context, February’s mortgage data re-enforces the messages from the UK and EA money sectors – central banks continue to tighten policy as the risks to the economic outlook intensify.
“Pschitt…”
Monthly mortgage flows in the UK and EA have fallen well below pre-pandemic level as air continues to escape from the regions’ RRE markets (see key chart above).
The 3m MVA of UK mortgage flows (£1.8bn) fell to 0.5x the pre-pandemic average flow of £3.9bn in February 2023. This marks three consecutive months of below pre-pandemic flows. The 3m MVA of EA mortgage flows (€4.2bn) fell to only 0.3x the pre-pandemic average flow of €12.5bn. The EA has seen four consecutive months of below pre-pandemic flows.
The rate of slowdown in mortgage lending flows is particularly sharp in the EA. Monthly flows have fallen from €25.9bn in June 2022 (2.1x pre-pandemic flows) to €4.2bn in February 2023 (0.3x pre-pandemic flows). This compares with respective multiples of 1.3x (June 2022) and 0.5x (February 2023) for UK mortgage flows.
Monthly mortgage flows – UK details
UK monthly mortgage flow dynamics (Source: BoE; CMMP)
Monthly UK mortgage flows fell to £0.7bn in February 2023, down from £2.0bn in January 2023 (see chart above). In relation to the pre-pandemic period, this is the lowest level of net borrowing since April 2016. February’s flow was only 0.2x the pre-pandemic flow of £3.9bn and well below the recent March 2022 peak of £7.5bn (1.9x pre-pandemic flows.)
The silver lining to these dark clouds was the fact that net approvals for house purchases increased to 43,500 in February from 39,600 in January. This was the first monthly increase in approvals since August 2022 and is important because approvals are an indicator of future borrowing.
Monthly mortgage flows – EA details
EA monthly mortgage flow dynamics (Source: ECB; CMMP)
Monthly EA mortgage flows rebounded to €5.1bn in February 2023, up from €2.8bn in January 2023 (see chart above). February’s flow was still only 0.4x the pre-pandemic average flow of €12.6bn and marks five consecutive months of below pre-pandemic average flows since October 2022.
Why the slowdown in mortgage flows matters
Mortgage demand typically displays a co-incident relationship with real GDP. In this context, February’s data re-enforces the messages from the UK and EA money sectors – central banks continue to tighten policy as the risks to the economic outlook intensify.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
Three warning signs from the rolling over in EA money and credit cycles
The key chart
Trends in nominal YoY growth rates in M3, M1 and private sector credit (Source: ECB; CMMP)
The key message
As growth in euro area (EA) money supply in February 2023 falls to its slowest rate (2.9% YoY) since October 2014, the “message from the money sector” includes three key warning signs for the ECB and for investors in the region:
Warning sign #1: banks’ top-line growth. Banks continue to experience net outflows of ST liabilities and a substitution away from low-cost overnight deposits to more expensive “other ST deposits”, at the margin (this is not just a US story). At the same time, credit growth is slowing i.e. negative price and volume effects.
Warning sign #2: house prices and household consumption. Monthly flows of mortgage and consumer credit have slowed sharply, to well-below pre-pandemic levels.
Warning sign #3 (re-enforced): weakening economic growth outlook. Leading, coincident and lagging monetary variables are slowing sharply and in a coordinated fashion at a time when access to finance is becoming more difficult and more expensive.
On 16 March 2023, ECB President Lagarde commented that, “we are beginning to see the transmission of our monetary policy.” Eleven days later, the money sector is adding the important detail – increased stresses for banks, households and the economic outlook for the euro area.
Will the “data dependent” central bank listen to its money sector and, if so, how will it respond? The risks of policy mistakes are rising as quickly as money and credit cycles are falling…
Still tightening as stresses mount
Trends in broad money growth since 2003 (% YoY, nominal terms) (Source: ECB; CMMP)
According to the latest ECB “Monetary Developments in the euro area” data release (27 March 2023), growth in broad money (M3) fell to 2.9% YoY in February 2023, down from 3.5% in January 2023 and 4.1% in December 2022. February’s growth rate was the slowest since October 2014.
Trends in broad money growth (% YoY) and breakdown of contribution (ppt) (Source: ECB; CMMP)
The sharp slowdown in narrow money (M1) is a key driver here. Recall that at the point of the January 2021 peak in M3 growth (12.5%), M1 contributed 11.3ppt to this total growth in broad money (see chart above).
This reflected the fact that households (HHs) and corporates (NFCs) were hoarding cash, largely in the form or overnight deposits, despite the fact that they were only earning a return of 0.01%. In stark contrast, narrow money fell -2.7% YoY in February 2023 as overnight deposits fell -2.7% YoY.
As money supply growth slows sharply, the message from the money sector behind these headline figures contains three key warning signs for the ECB and for investors in the region.
Warning sign #1 – banks’ top line growth
Monthly flows of ST liabilities by type (EUR bn) (Source: ECB; CMMP)
Banks continue to experience net outflows of ST liabilities and a substitution away from low-cost overnight deposits to more expensive “other ST deposits”, at the margin. Continuing the theme from “Competing for funding”, EA banks have experienced outflows of ST liabilities in four of the past five months. This reflects six consecutive months of overnight deposits outflows (the blue columns in the chart above). Inflows in other ST deposits (within M2-M1 above) and, to a lesser extent, marketable securities (within M3-M2) have not been able to compensate. They also come at a higher cost.
Trends in private sector credit growth (% YoY) and breakdown of contribution (ppt) (Source: ECB; CMMP)
At the same time, credit growth is slowing. Adjusted private sector credit (PSC) growth peaked recently at 7.1% YoY in September 2022. NFC credit grew 8.9% at this point and made the largest contribution to total loan growth (3.5ppt). HH credit grew 4.4% and contributed 2.3ppt.
By February 2023, PSC growth had slowed to 4.3% YoY. NFC credit growth slowed to 5.7%, but remained the largest contributor to total PSC growth (2.2ppt). HH credit growth slowed to 3.2% YoY, a 1.7ppt contribution to total PSC growth.
Warning sign #2: house prices and household consumption
Trends in monthly mortgage flows (EUR bn) (Source: ECB; CMMP)
Monthly flows of mortgage and consumer credit have slowed sharply to below pre-pandemic levels.Monthly mortgage flows slowed to €5.1bn in February 2023, from €13.7bn a year ago (see chart above). Note that the growth in the outstanding stock of EA mortgages peaked at 5.8% in August 2021 and slowed noticeably after June 2022. February’s growth rate was 3.7% YoY, the slowest growth rate since November 2019.
Monthly consumer credit flows fell to €1.9bn in February 2023 from €3.4bn a year earlier (see chart above). Note that while consumer credit flows have recovered, they have remained below the average pre-pandemic flows of €3.4bn throughout the post-pandemic period. This is in contrast to trends observed in the US and the UK.
Monthly mortgage and consumer credit flows as a multiple of pre-pandemic average flows (Source: ECB; CMMP)
With monthly mortgage and consumer credit flows falling to 0.30x and 0.33x their respective pre-pandemic average monthly flows(see chart above), the EA money sector is sending clear warning signs for future house prices and HH consumption in the region.
Warning sign #3 (re-enforced): weakening economic growth outlook
Trends in real M1, HH credit and NFC credit (% YoY, real terms) (Source: ECB; CMMP)
Leading, coincident and lagging monetary variables are slowing sharply and in a coordinated fashion at a time when access to finance is becoming more difficult and more expensive. Real growth rates in M1, HH credit and NFC credit typically display leading, coincident and lagging relationships with real GDP. The sharp and coordinated slowdown in these variables has been sending warning signs from some months now. If historic relationships between these variables continue, this suggest that economic activity will decelerate over the next quarters.
Conclusion
On 16 March 2023, ECB President Lagarde commented that, “we are beginning to see the transmission of our monetary policy.” Eleven days later, the money sector is adding the important detail – increased stresses for banks, households and the economic outlook for the euro area.
Will the “data dependent” central bank listen to its money sector and, if so, how will it respond? The risks of policy mistakes are rising as sharply as money and credit cycles are falling…
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
