Peter Praet: Opening remarks - "Money markets, monetary policy
implementation and central bank balance sheets"
Speaking points by Mr Peter Praet, Member of the Executive Board of the European Central
Bank, at the ECB Workshop on "Money markets, monetary policy implementation and central
bank balance sheets", Frankfurt am Main, 6 November 2017.
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Introduction
It is my pleasure to welcome you to this year's edition of the ECB ́s Workshop on "Money
markets, monetary policy implementation and central bank balance sheets".
I would like to make some remarks on the role that money markets, monetary policy
implementation and central bank balance sheets have played in our recent monetary policy
decisions.
The October monetary policy decision
At its October meeting, the Governing Council decided to extend its net asset purchases within
the asset purchase programme (APP) at a monthly pace of €30bn for nine months until the end
of September 2018, or beyond, if necessary.
The Governing Council re-iterated that it expects the key ECB policy rates to remain at their
present levels for an extended period of time, and well past the horizon of our net asset
purchases.
This decision was taken against the backdrop of the solid and broad-based economic expansion
which the euro area continues to experience.
Our monetary policy measures have been effective and are reflected in recent economic
developments. Deflationary risks have disappeared. Some measures of underlying inflation have
ticked up over recent months, but have yet to show more convincing signs of a sustained upward
trend. Overall, inflation developments, despite the solid growth, have remained subdued.
Importantly, the convergence of inflation towards our aim remains conditional on a substantial
degree of monetary policy accommodation.
A "sustained adjustment in the path of inflation" is the principal condition that has guided, and will
be guiding, the calibration of our asset purchase programme (APP).
An extension of the programme was warranted by the continued need for a substantial amount of
monetary policy accommodation to ensure the desired inflation convergence.
When considering the appropriate calibration of the APP there were three important dimensions
to consider: pace, horizon and optionality.
As regards the first dimension, pace, the brighter economic prospects have increased our
confidence in the gradual convergence of inflation towards our aim. This called for a lower
pace of purchases.
Second dimension, horizon: We have always emphasised that monetary policy needs to be
persistent and patient for underlying inflation pressures to gradually build up. This speaks in
favour of a sufficiently long horizon of additional net purchases. The longer horizon also
anchors short-term interest rate expectations for a longer period, thereby reinforcing the
Governing Council's forward guidance on policy rates.
The third dimension is optionality: Retaining the option to re-calibrate the APP if warranted is
consistent with the forward guidance on the APP.
Key channels of the APP
There are two key channels through which the APP operates. The first is the extraction of
duration risk, which propagates through portfolio rebalancing. The second key channel is the
signalling channel on interest rates.
The duration risk channel and the signalling channel correspond to the two components of the
long-term interest rates through which a central bank can seek to influence the level and shape
of the yield curve: the expectations component and the term premium.
How does the APP influence the term premium? By accumulating a portfolio of long-duration
assets, the central bank extracts duration risk from private hands, frees up risk bearing capacity
in the markets, spurs a rebalancing of private portfolios towards the remaining securities, and
thereby lowers term premia and yields across a range of financial assets. Duration extraction is
thus the catalyst for the portfolio rebalancing channel, which is the main mechanism by which
easing through quantitative interventions is then transmitted further through the economy.
Now, what matters in particular for term premia is the entire stock of duration which the central
bank removes from the hands of price-sensitive investors by taking this stock of duration on its
balance sheet. As a result, the continued monetary support from assets purchases is not only
provided by the additional net asset purchases, but also by the sizeable stock of already acquired
assets and the forthcoming reinvestments.
The second key channel is the signalling channel: the expectations component of long-term
yields reflects market expectations of the future path of the policy-controlled short-term interest
rates. In this respect the sequencing embodied in our forward guidance gives significant strength
to the signalling channel.
The sequencing firmly anchors expectations for short term interest rates. The Governing Council
expects the key policy rates "to remain at their present levels for an extended period of time, and
well past the horizon of our net asset purchases".
The role and function of money markets
For the signalling channel to operate it is essential that the monetary impulses are transmitted
through money market rates. In this regard let me make a number of observations.
Fragmentation
First, for monetary policy impulses to be transmitted through money market rates, it is important
that money markets are not fragmented. Last time I addressed this workshop, which was in
2013, the backdrop provided by market conditions was quite different from what it is now. At that
time, we observed elevated fragmentation in money markets. This related in part to sovereign
risks which were prevalent at that time.
Since the sovereign debt crisis, the overall levels of fragmentation have receded sharply. The
dispersion of risk-adjusted borrowing rates across countries is now relatively low.
Of course, rate-based indicators do not give direct evidence of the degree to which trading is
taking place across borders. But an assessment of fragmentation based on trading quantities
would be anyway rather elusive. The high level of aggregate excess liquidity has significantly
curtailed the need for trading liquidity.
The fact that money market rates, adjusted for credit risks, have largely converged speaks in
favour of a much reduced level of fragmentation and a more homogenous degree of access to
liquidity across the euro area. This is also supported by the fact that the interest rates observed
across countries are more correlated with aggregate excess liquidity levels rather than
countryspecific levels.
Unsecured vs. secured segments
Second, we have observed a sustained shift of money market activity from the unsecured to the
secured segment. Activity in the unsecured segment has declined significantly over time, in the
first place due to the heightened counterparty risk in the wake of the crisis. Activity in the
unsecured market has stabilised but remains subdued. This is linked to the high level of excess
liquidity and reduced short-term funding needs for banks, as well as, to some extent, regulatory
changes affecting banks' liquidity management.
The ECB has never singled out one specific short-term interest rate as its operational target, but
it is clear that the EONIA, an unsecured money market rate, has provided an important point of
reference to practitioners.
The observed shift of activity from the unsecured to the secured market raises a number of
important questions. For instance: Do unsecured rates still have the same information content
as before the crisis? Is the arbitrage between secured and unsecured rates working efficiently?
And, should the central bank focus more on steering secured rather than unsecured rates?
In this regard it is also relevant that we have seen some divergence between secured and
unsecured rates, which also relates to some extent to our monetary policy measures.
While the ECB deposit facility rate has provided a floor for the EONIA, certain repo rates have
come to trade significantly below OIS rates, especially for repos secured by collateral of the
highest credit quality.
This reflects to some extent our monetary policy measures. By removing securities from the
market, the ensuing scarcity exerts downward pressure on repo rates. For instance, specialness
premia tend to be higher in those market segments where the Eurosystem has purchased more
bonds relative to outstanding amounts.
Differentiation within the secured segments
Even looking at the unsecured segment, we see some differentiation of transaction rates, which
results to some extent from the way the liquidity created by our measures interacts with market
participants' access to our deposit facility.
While unsecured trading between banks with access to our deposit facility is taking place above
the deposit facility rate, institutions without access are willing to lend at rates below the deposit
facility rate. The distribution of liquidity to entities without access to the deposit facility is amplified
by our asset purchases, which mechanically channel liquidity to large financial institutions
located outside of the euro area.
The phenomenon that we see of money market rates below policy rates is not unique to the euro
area, but is visible in most, if not all, cases where asset purchases have significantly ramped up
excess liquidity. Take for example the US, where the Federal Funds rate is trading below the
Fed's Interest Rate on Excess Reserves. This is due to the fact that the Fed Funds Rate to a
significant extent reflects transactions between banks that can earn interest on reserves and
Federal Home Loan Banks that cannot. Moreover, as US repo rates traded at even lower levels
to the extent that they largely reflect trades with non-banks that do not hold a Fed account such
as government sponsored entities and money market funds, the Fed introduced its overnight
reverse repurchase agreement operations (RRPs), which has allowed it to effectively steer
money market rates and engineer a successful lift-off of rates.
In the euro area, institutions without access to the deposit facility currently lend in money markets
at rates below the deposit facility rate to those that have access to the facility. These low rates
can be seen as reflecting the continued very accommodative stance of monetary policy. This
situation, however, is worth studying further, as it is relevant when thinking about the operational
framework in the longer run.
Conclusion
The brighter economic prospects have increased our confidence in the gradual convergence of
inflation towards our aim. At the same time, a substantial amount of monetary accommodation
continues to be necessary to secure the gradual convergence of inflation towards our inflation
aim.
The continued monetary support is provided by the additional net asset purchases, by the
sizeable stock of acquired assets and the forthcoming reinvestments, and by our forward
guidance on interest rates.
To this end, an effective transmission of our monetary support through the money market
remains essential. I thus look forward to hearing back about the discussions which you will be
having about money markets. I think it is very useful and important that this workshop brings
together academics, central bankers and market practitioners, which provides for a variety of
perspectives. I wish you a very productive workshop.