The key chart
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.
Trends in HH savings rate (% gross disposable income) (Source: ECB; CMMP)
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”.
Monthly flows (EUR bn) in HH consumer credit demand (Source: ECB; CMMP)
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.