They key chart
Trends in 12-month cumulative flows (EUR bn) presented in a stylised consolidated balance sheet format (Source: ECB; CMMP)
The key message
CMMP Analysis focuses on the implications of the relationship between the money sector and the real economy for macro policy, strategy, investment decisions and asset allocation. Monetary aggregates provide key insights into this relationship and their dynamics help us to understand the impact of monetary policy on money and the financing of the economy.
This post reviews the impact of unprecedented policy tightening by the ECB on money and financing for the euro area (EA) in 2023: what happened; why it happened; and why it matters.
Money flows fell sharply on a 12-month cumulative basis to only €18bn in 2023, down from €590bn in 2022 and €1,009bn in 2021. This dramatic contraction reflects three key factors – the rising opportunity costs of money, portfolio rebalancing and a collapse in bank lending:
- Policy tightening increased the opportunity cost of holding money and triggered a re-allocation of overnight deposits to better-remunerated, other ST deposits. Outflows from narrow money or M1 (currency plus overnight deposits) reached €-965bn, from inflows of €23bn in 2022 and €1,018bn in 2021. Inflows to other ST deposits (M2-M1) reached €824bn, from €484bn in 2022 and outflows of €55bn in 2021. Inflows into “marketable instruments” (M3-M”) rose to €158bn in 2023, from €83bn in 2022 and €46bn in 2021.
- The phasing out of net asset purchases and TLTROs incentivised bank bond issuance and encouraged portfolio rebalancing away from deposits to LT bank liabilities. Flows into LT liabilities rose to €345bn in 2023, from €38bn in 2022. Note that the latter do not form part of monetary aggregates, by definition.
- Bank lending, the principal source of money creation (deposits) collapsed. Cumulative flows of lending to the private sector fell to only €40bn in 2023 (within total credit of €72bn in table above), from €624bn in 2022 and €476bn in 2021.
The contraction in narrow money during 2023, while dramatic, was neither an indicator of liquidity problems for EA banks nor a reliable indicator of economic activity or future inflation. At least not in itself. It was, instead, an example of how policy “normalisation” leads to re-adjustments in the structure and dynamics of bank balance sheets.
The collapse in financing flows to the private sector was far more serious. The pace of change of policy, policy transmission, and policy response is unprecedented and leaves the ECB and EA households and corporates without a playbook.
Dramatically reduced financing flows, historically high policy rates and increased borrowing costs are an unsustainable combination that suggest that the risk of policy errors remains very high at the start of 2024.
Money and financing the EA economy, 2023
CMMP Analysis considers the impact of the ECB’s unprecedented monetary policy on money and financing of the euro area (EA) economy from the perspective of monetary dynamics.
Recall that monetary aggregates are derived from the liabilities side of the consolidated balance sheet of monetary financial institutions (MFIs). Money is then classified according to its liquidity or degree of “moneyness” e.g. narrow money (M1, the most liquid), intermediate money (M2), and then broad money (M3), in the case of the euro area
The calculation of money supply involves adding these components together – in essence, the sum of currency in circulation plus the outstanding amount of financial instruments that have a high degree of moneyness. The simplest way to think about money, therefore, is as the short-term liabilities of the banking sector (note that longer-term liabilities are excluded from the definition of broad money as they considered portfolio instruments rather than as a means of transacting)
M3 = M1 (currency plus overnight deposits) plus M2-M1 (other ST deposits) plus M3-M2 (marketable instruments)
Money can also be calculated and understood by re-arranging the so-called “counterparts of money”, i.e. all items other than money on both sides of the consolidated balance sheet. Hence M3 in the euro area can also be calculated as:
M3 = credit to EA residents + net external assets – longer term liabilities + other counterparts
What happened in 2023 and why?
The collapse in money flows (EUR bn, 12m cumulative) to the euro area (Source: ECB; CMMP)
Money flows fell sharply on a 12-month cumulative basis to only €18bn in 2023, down from €590bn in 2022 and €1009bn in 2021 (see chart above). This dramatic contraction reflects three key factors – the rising opportunity costs of money, portfolio rebalancing and a collapse in bank lending.
The collapse in money flows (EUR bn, 12m cumulative) from a components perspective (Source: ECB; CMMP)
Policy tightening increased the opportunity cost of holding money and triggered a re-allocation of overnight deposits to better-remunerated, other ST deposits. Outflows from narrow money or M1 (currency plus overnight deposits) reached €-965bn, from inflows of €23bn in 2022 and €1018bn in 2021 (the blue columns above). Inflows to other ST deposits (M2-M1) reached €824bn, from €484bn in 2022 and outflows of €55bn in 2021 (the maroon columns above). Inflows into “marketable instruments” (M3-M”) rose to €158bn in 2023, from €83bn in 2022 and €46bn in 2021 (the green columns above).
Portfolio rebalancing and flows to LT liabilities (EUR bn, 12m cumulative) (Source: ECB; CMMP)
The phasing out of net asset purchases and TLTROs incentivised bank bond issuance and encouraged portfolio rebalancing away from deposits to LT bank liabilities (see chart above). Flows into LT liabilities rose to €345bn in 2023, from €38bn in 2022. Note that the latter do not form part of monetary aggregates, by definition.
The collapse in PS financing flows (EUR bn, 12m cumulative) to the euro area (Source: ECB; CMMP)
Bank lending, the principal source of money creation (deposits) collapsed. Cumulative flows of lending to the private sector fell to only €40bn in 2023 (within total credit of €72bn in table above), from €624bn in 2022 and €476bn in 2021 (see chart above).
Why these trends matter
The contraction in narrow money during 2023, while dramatic, was neither an indicator of liquidity problems for EA banks nor a reliable indicator of economic activity or future inflation. At least not in itself. It was, instead, an example of how policy “normalisation” leads to re-adjustments in the structure and dynamics of bank balance sheets.
The collapse in financing flows to the private sector was far more serious. The pace of change of policy, policy transmission, and policy response is unprecedented and leaves the ECB and EA households and corporates without a playbook.
Dramatically reduced financing flows, historically high policy rates and increased borrowing costs are an unsustainable combination that suggest that the risk of policy errors remains very high at the start of 2024.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.