Tag: Monetarypolicy

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:

1. What is the BLC and how does it work?
2. How does the current cycle compare with the previous 2005-08 cycle?
3. 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:

1. The scale and pace of the policy response
2. The very slow/limited pass through from higher policy rates to the cost of overnight deposits
3. 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.

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:

1. What is the BLC and how does it work?
2. How does the current hiking cycle compare with the previous 2005-08 cycle?
3. 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.