Its summer! After reading this blog – The ECB is a major reason the Euro crisis is deepening – many readers have written to me asking to provide more explanation of the “sterilisation” operations that the ECB is engaged in. It is clear that an increasing number of people are becoming interested in arcane things like central bank operations which can only augur well for creating capacity for better public debate. A lot of readers overnight have reacted one way or another to the announcement by several central banks that the swap lines are open again albeit at a lower “cost” than previously. There was also considerable interest in understanding what the “failed” sterilisation yesterday means. The answer is not much but we had better not tell the Germans that the ECB weekly deposit tender failed.
In a recent blog – The ECB is a major reason the Euro crisis is deepening – I provided the most recent data applicable to the ECBs so-called Securities Market Programme (SMP) which was established on May 14, 2010.
You can read more recent information about the programme HERE. The ECB provides the weekly Data (click on the Ad-hoc communications Tab) about the SMP purchases. The ECB announced their SMP in this Statement.
As of November 25, 2011 the ECB has bought 203.5 million euros worth of bonds under the programme. The purchases are accelerating each week.
Since August 2011, the ECB has accelerated their purchases in the secondary bond markets to overcome the fact that the private bond markets have been increasingly less willing to fund EMU member states at affordable yields.
This is evidenced by the widening spreads of member state bonds against the Bund. The SMP is unambiguously a fiscal bailout package which amounts to the central bank ensuring that governments can continue to function (albeit under the strain of austerity) rather than collapse into insolvency.
When the ECB announced the SMP they also said that:
With a view to leaving liquidity conditions unaffected by the programme, the Eurosystem re-absorbs the liquidity provided through the SMP by means of weekly liquidity-absorbing operations. The intended amount for absorption equals the cumulative size of settled SMP transactions at the end of the preceding week, rounded to the nearest half billion.
See also the ECB Annual Report 2010 for more discussion.
As a consequence, the ECB conducts a weekly open market operation in the form of the provision of fixed-term deposits (with a weekly duration) which economists refer to as a sterilisation operation.
The sterilisation concept usually refers to open market operations conducted by a central bank to insulate the effects on the money supply caused by a balance of payments surplus or deficit. It is typically a concept that applied during the Bretton Woods era where central banks were entrusted with maintaining the fixed exchange rates under the agreement.
So if a nation was running a current account deficit, it would face downward pressure on its exchange rate (because more people were supplying the local currency into foreign exchange markets to buy imports relative to those which were demanding the local currency to buy a nation’s exports).
The central bank would have to intervene to prevent the exchange rate falling and they would buy local currency in exchange for its reserves of foreign currency in the forex market and thus soak up the excess supply of local currency and maintain the parity.
However, without any accompanying operation, this would result in the domestic money supply contracting which would drive up the local interest rate and compromise the health of the local economy.
To insulate the domestic economy from the foreign exchange intervention, the central bank could then sterilise the intervention by buying bonds in the local bond markets in return for currency and thus maintain the money supply and interest rates at their desired levels.
There are other examples of sterilisation (for example, when an exchange rate is under upward pressure). But I am sure you get the point.
On December 2, 2010, the then ECB President Jean-Claude Trichet held a Press Conference and the following exchange occurred:
Question: You described the SMP programme as an instrument that enables you to implement your monetary policy in abnormal circumstances. If circumstances get worse, would you be willing to extend this programme?
Trichet: From the very beginning, the aim of the programme has been to help us restore the functioning of our monetary policy transmission mechanism, and it is for the Governing Council to judge how best to do this. It is not quantitative easing; we are withdrawing all the liquidity that we are injecting.
So no quantitative easing – spare the thought!
In a speech on October 21, 2011, a member of the Executive Board of the ECB (José Manuel González-Páramo) – The ECB’s monetary policy during the crisis said in relation to the SMP that:
The main purpose of this programme is maintaining a functioning monetary policy transmission mechanism by promoting the functioning of certain key government and private bond segments … The SMP should, of course, be clearly distinguished from the policy of quantitative easing. While the objective of the SMP is to repair the transmission mechanism, quantitative easing aims at injecting additional central bank liquidity in order to stimulate the economy. As a result, quantitative easing, as for instance with the Bank of England, comes with precise quantitative targets. By contrast, the size of SMP purchases is driven by an intervention strategy which seeks to improve market functioning. Let me stress that the liquidity injected through SMP purchases is re-absorbed on a weekly basis so as to specifically neutralise the programme’s liquidity impact.
The ECB has tried to distance itself from other central banks (such as the US Federal Reserve, the Bank of England and the Bank of Japan) who they consider have exposed their economies to excessive inflation risk by “printing too much money” under their respective quantitative easing programs.
The ECB also continues to peddle the myth that QE is about giving banks more money to lend. The fallacy in that logic is that bank lending has not be constrained by a lack of reserves. Rather there has been a dearth of credit-worthy customers at a time when banks have tightened their lending criteria given the financial uncertainty.
Please read my blog – Quantitative easing 101 – for more discussion on this point.
Quantitative easing is an asset swap designed to bid up the prices of assets in certain maturity ranges and thus keep interest rates in those segments lower.
The only way it would have helped alleviate the crisis is if the lower rates stimulated investment growth. However, with the crisis so deep and consumers bunkering down for fear of unemployment and insolvency (given the debt overhang), firms have been able to satisfy demand with existing capacity.
Further, the fact that most central banks have been offering a return on excess bank reserves means that the SMP is virtually indistinguishable.
Both keep yields lower than otherwise by strengthening demand in the bond markets and both provide an interest-bearing alternative to the bond-holders.
The SMP is however targeted at bailing out governments by buying their debt and taking the risk of default off the private sector.
Modern Monetary Theory (MMT) explains why this view about QE is erroneous. It also explains why QE itself has failed to expand aggregate demand.
There have been a lot of questions asked about the sterilisation operations conducted by the ECB including its limits. The distance that the ECB has been trying to make between the SMP and QE has also been challenged.
First, it is clear that the scale of the SMP is well beyond that necessary to fulfil the objectives that are officially ascribed to the program – “to restore depth and liquidity to dysfunctional markets”.
Second, the neutralising of the SMP purchases does not reduce the capacity of commercial banks to expand credit. If you think that the weekly fixed deposits actually reduce the capacity of the commercial banks to lend then you would be wrong.
The SMP works like this – an EMU government issues bonds to the private market who knows they can sell them to the ECB and thus eliminate any carry risk. The ECB buys the bonds in the secondary market (that is, after they have been issued by the EMU government in the primary tender market) with euros which it creates.
At that point, bank euro deposits and reserves rise.
The inflation risk is in the spending that the bond issue “funded” (when we talk about an EMU nation). There is no inflation risk in the rising bank reserves.
The ECB then offers deposits with the ECB up to the volume of outstanding SMP bond purchases. So they swap the euros for an interest earning account with the ECB instead of leaving the interest-earning bond in the hands of the private sector.
The sterilisation operation drains bank reserves (moving them into a different account at the ECB) while the commercial bank deposit remains.
The commercial banks effectively view the weekly fixed deposits as close substitutes for reserves. And as we know they don’t lend reserves anyway.
Moreover, the banks can always access unlimited funds via the marginal lending facility which I will explain next.
The other part of the picture that you might want to understand is that central banks offer commercial banks what are called Standing Facilities.
This document – The Implementation of Monetary Policy in the euro Area February 2011 – provides a broad description of the various operations that the ECB conducts.
In terms of Standing facilities, the ECB (Section 1.3.2 Standing facilities) says:
Standing facilities are aimed at providing and absorbing overnight liquidity, signal the general stance of monetary policy and bound overnight market interest rates. Two standing facilities are available to eligible counterparties on their own initiative, subject to their fulfilment of certain operational access conditions …
- Counterparties can use the marginal lending facility to obtain overnight liquidity from the national central banks against eligible assets. Under normal circumstances, there are no credit limits or other restrictions on counterparties’ access to the facility apart from the requirement to present sufficient underlying assets. The interest rate on the marginal lending facility normally provides a ceiling for the overnight market interest rate.
- Counterparties can use the deposit facility to make overnight deposits with the national central banks. Under normal circumstances, there are no deposit limits or other restrictions on counterparties’ access to the facility. The interest rate on the deposit facility normally provides a floor for the overnight market interest rate.
The standing facilities are administered in a decentralised manner by the national central banks
So the weekly fixed-term deposits that the ECB is using to drain the liquidity injected via the SMP are very similar to the standard Deposit Facility, which allows the banks to make overnight deposits with the ECB.
Recall that to manage the interest rate target, the central bank cannot leave excess reserves in the payments system unless it offers an interest rate commensurate with the spread it is prepared to tolerate around its target rate.
If they do not offer a return to banks on excess overnight funds (which are only used to ensure integrity in the settlements (payments) system) then the banks will compete among each other in the interbank market to see if they can get a better rate (above zero) and the competition drives the overnight rate down to zero.
Remember that the non-government sector cannot eliminate a system-wide excess of liquidity because every asset created (loan) is matched by an equivalent liability (debt).
The only way the excess reserves can be drained is via the central bank selling government debt to the banks. Paying a return on the excess overnight reserves is an equivalent action.
The Deposit facility works in that way. If you click the Data Tab at the ECB Standing facilities page you will see the following information.
So the Deposit facility rate yesterday was 0.5 per cent. You can see the history of the Deposit facility rate HERE. In 2009, the rate was 0.25 per cent up to April 13, 2011 when it rose to 0.5 per cent. It was pushed up again by the ECB on July 13, 2011 to 0.75 per cent but that was adjusted downwards again to 0.5 per cent on November 9, 2011.
So keep all that in mind and wonder how the Deposit facility is different to the sterilisation operation?
Both are voluntary. The commercial banks do not have to use the Standing facilities nor do they have to bid for the weekly, fixed-term deposit facilities.
What do we know about the sterilisation operation?
You can also download their entire open market operations dataset and if you sort through it and trace the tenders (they all occur at 12.05 – just after midday) you can match the sterilising operations (the so-called fixed variable tender auctions) to the SMB cumulative balance.
You can also see an html page providing some of the details of the open market operations. If you click the link market ANN (meaning annotations) you can find out more detail about the specific transaction.
In their weekly memorandum relating to the latest (November 29, 2011 bids for November 30, 2011 settlement), the ECB said:
As announced by the Governing Council on 10 May 2010, the ECB conducts specific operations in order to re-absorb the liquidity injected through the Securities Markets Programme (SMP). In this regard, the ECB will carry out a quick tender on 29 November at 11.30 in order to collect one-week fixed-term deposits with settlement day on 30 November. A variable rate tender with a maximum bid rate of 1.25% will be applied and the ECB intends to absorb an amount of EUR 203.5 billion.
The latter corresponds to the size of the SMP, taking into account transactions with settlement on or before Friday 25 November, rounded to the nearest half billion. As the SMP transactions which settled last week were of a volume of EUR 8,581 million, the rounded settled amount – and the intended amount for absorption accordingly – increased to EUR 203.5 billion.
So they currently have purchased EUR 203.5 billion worth of European government bonds in the secondary bond markets and are the sole reason that several European member states are still solvent.
The following graph shows you the SMB balances and the volumes drained by the weekly auctions. The latest auction (red arrow) was settled yesterday (November 30, 2011).
In the November 30, 2011 liquidity absorption operation (the sterilising action), the ECB sought to drain 203.5 Euros.
Here is the data from the most recent auction that was settled yesterday.
According to this data, the sterilisation failed. The banks only decided to deposit 194.2 billion euros in the weekly fixed-term deposits. The 9.3 billion euro shortfall is almost equivalent to the SMP purchases in the week to November 25, 2011 (9 billion euros).
But before we get carried away, the graph shows that there has not been complete sterilisation on several occasions since the SMP began in May 2010.
The following tenders “failed” – June 30, 2010 (the ECB sought to sterilise 55 billion euros and there were only 31.9 billion euros deposited); August 25, 2010 (sought 61 billion euros and 60.5 billion euros were deposited); December 29, 2010 (sought 73.5 billion euros and 60.8 billion euros were deposited); February 2, 2011 (sought 76.5 billion, deposited 68.2 billion); April 27, 2011 (sought 76 billion, deposited 71.4 billion); May 4, 2011 (sought 76 billion, deposited 62.2 billion); and finally November 30, 2011 (sought 203.5 billion, deposited 194.2 billion).
What does the current “failure” mean?
Not much. It tells us that in a technical sense, it means that the banks have determined that they prefer to keep some of the funds gained from the SMP in as liquid a form as possible.
The average daily increase in the Deposit facility has been 617 million euros. The ECB Historical data on daily liquidity conditions – shows that the increase in the deposits were 25159 million euros on November 29, 2011 and a further 15694 million euros on November 29, 2011.
It is highly likely that the commercial banks prefer to use this facility (which is an overnight deposit) despite the loss of 0.12 per cent in return.
What this probably signals is that a week is a long time in the current Eurozone banking system.
The other point to note is that ECB is paying 0.62 per cent over the next week for the Fixed-term deposits but are paying 0.5 per cent through the Standing facility. Why would they do that? Why give the banks a 0.12 per cent margin? There is no reason for that.
Essentially, these are excess reserves held by the commercial banks at the ECB. The banks would usually take up the 0.5 per cent instead of holding them as zero-earning reserves. So why add the extra 0.12 per cent?
This also bears on the conservative claims that the sterilisation will reach a limit and then the inflation risks will rise.
The Deposit facility has no limits and banks will usually prefer to park their excess reserves there anyway. But whatever arrangement the banks use to handle their excess reserves, none impact on inflation risk.
Even if the weekly tenders attracted zero bids, the inflation risk in the Eurozone would not change.
I hope that answered the many questions I have received about the SMP and the sterilisation operations.
In terms of inflation risk, the operations are neutral. The ECB might think they are being virtuous but when you understand what they are doing – the weekly auction just seems to be offering a superior return on excess reserves than the existing Standing facility.
None of these operations reduce the capacity of the banks to expand credit to the private sector.
That is enough for today!