SPEECH

Central bank liquidity: a macroeconomic
perspective

Welcome address by Philip R. Lane, Member of the Executive
Board of the ECB, at the ECB Conference on Money Markets

Frankfurt am Main, 9 November 2023

Introduction

My aim in these opening remarks is to explore the macroeconomics of central bank liquidity. In
particular, my focus is on how central bank reserves can influence macroeconomic outcomes. In tum, if
central bank reserves are relevant for the level and volatility of economic activity and inflation, the
calculation of the appropriate level of central bank liquidity should take into account the (time-varying)

macroeconomic impact.)

The macroeconomic analysis of central bank reserves is necessarily subject to high uncertainty, since it
is challenging to control for various confounding factors in conducting empirical analysis. In particular, the
creation of central bank reserves on the liability side of the central bank balance sheet is typically
matched by an increase in collateralised loans (refinancing operations) to banks or an increase in asset

purchases on the asset side.!2] Refinancing operations (including targeted versions that require banks to
meet a credit growth or credit composition target to benefit from favourable funding conditions) and asset
purchases have direct macroeconomic effects that have been much studied, while the macroeconomic

impact of the liability side of these interventions has received comparatively less attention.)

Over the last decade, much of the expansion in central bank reserves in the euro area has been a by-
product of quantitative easing (large-scale asset purchases) or targeted longer-term refinancing
operations (TLTROs). These policies were motivated by their direct impact on bond markets and credit
dynamics. In line with the ECB's 2021 monetary policy strategy statement, from a stance perspective,
the activation of such policies is only relevant in the neighbourhood of the effective lower bound (ELB) on

policy rates.'4] Away from the ELB, by contrast, the short-term policy rate is the primary instrument to

steer the monetary policy stance.

Central bank reserves in the euro area have also been created in the context of managing financial stress
episodes. These include the surge in the take-up of refinancing operations during the Global Financial
Crisis (GFC) and the launch of the three-year very long-term refinancing operations (VLTROs) in 2011 and
2012. In terms of bond market stabilisation, the Securities Markets Programme (SMP) purchased bonds
of stressed countries between May 2010 and February 2012.!5! Initiated in March 2020, the pandemic
emergency purchase programme (PEPP) was a hybrid of a market-stabilisation programme and a
quantitative-easing programme. The ECB's monetary policy strategy statement recognised that financial
stability is a precondition for price stability and that the pervasive role of macro-financial linkages in

economic, monetary and financial developments requires that monetary policy decisions, including the
evaluation of the proportionality of these decisions and potential side effects, are based on an integrated
assessment of all relevant factors. Accordingly, their roles in preserving and restoring financial stability

are central in understanding the macroeconomic impact of central bank reserves.

In addition to the role of central bank reserves under non-standard conditions (whether proximity to the
ELB and/or stressed circumstances), it is also important to assess the possible macroeconomic impact
of the structural level of central bank reserves in the new steady state that will emerge after the roll back

of QE-inspired asset purchase programmes and the expiry of the TLTRO programme." In particular, the
appropriate level of central bank reserves can be expected to remain much higher and be more wolatile in
this new steady state compared to the relatively-low levels that prevailed before the global financial crisis
(GFC). Amongst other factors, the extraordinary macro-financial risk episodes (the GFC, the euro area
sovereign debt crisis, the pandemic) in the last 15 years have underlined the importance of financial

institutions maintaining significant liquidity levels.!2] For banks, central bank reserves are the ultimate
liquid and risk-free (including zero valuation risk, zero counterparty credit risk and zero operational risk)
asset. In turn, the liquidity options available to non-bank financial institutions (which do not have access

to ECB liquidity facilities) depend on the liquidity conditions in the banking system.!&

Central bank reserves: some stylised facts

To set the scene, Charts 1 and 2 show the role of central bank reserves in the balance sheet of the euro
area banking system. Chart 1 plots the ratio of central bank reserves to total banking assets, while Chart
2 plots the ratios to some asset categories: loans, bond holdings and the stock of high-quality liquid
assets (HQLA). We see that all of these metrics increased substantially when the ECB implemented its
quantitative easing and targeted lending programmes but have eased noticeably from their peaks over the
last year (the stock of central bank reserves peaked at EUR 4.92 trillions in November 2022).

Chart 1
Bank reserves over total assets

(percentages)

it)
2006 2011 2016 2021 June 2023

Sources: ECB (BSI) and ECB calculations.
Note: The latest observation is for the second quarter of 2023.

Chart 2
Euro area central bank reserves relative to selected balance sheet metrics

(percentages)

mmm Bank reserves over HOLA ---=-= Bank reserves over government bond holdings nates over total loansto euro area

100 400 40

75 300 30

50 200 20

25 100 10

it) Q it}
April 2020 October 2021 June 2023 2006 2015 June 2023 2006 2015 June 2023

Sources: ECB (BSI, SUP) and ECB calculations.

Notes: High-quality liquid assets (HQLA) are computed as the sum of unadjusted amounts of level 1 and level
2 assets from supervisory data. Less significant institutions' HQLAin the second quarter of 2023 are based on
data for the first quarter of 2023 and projected using the quarterly growth rate of significant institutions' HQLA.
Bank reserves are the sum of bank deposits with the Eurosystem in both the deposit facility and current
account. Government bond holdings refer to debt securities issued by the euro area general government sector
and held by euro area credit institutions. Total loans to euro area residents exclude those to monetary financial
institutions and correspond to those held on bank balance sheets (i.e. they are not adjusted for securitisation
and cash pooling). The latest observations are for the second quarter of 2023.

Turning to the balance sheet of the Eurosystem, Charts 3-5 show the evolution of liabilities and assets.
On the liability side, Chart 3 shows the relative contributions of central bank reserves, banknotes and
other liabilities to the evolution of the balance sheet. On the asset side, Chart 4 shows the relative
importance of the monetary policy outright portfolio of bond holdings and credit operations, as well as
non-monetary policy assets on the Eurosystem balance sheet, including assets held for investment
purposes. In turn, Chart 5 shows the mix of credit operations across three categories: one-week
operations (I will label these as short-term refinancing operations - STROs - which are primarily provided
through the main refinancing operations (MROs) in the euro area); the sum of 30-day and 90-day
operations (I will label these as medium-term refinancing operations - MTROs); and operations with at

least one year in duration (I will label these as longer-term refinancing operations - LTROs)./21

Chart 3
Eurosystem liabilities

(EUR trillions)

@ Central bank reserves @ Other liabilities
Currency = Total liabilities
Official sector and other deposits

1

0
2002 2008 2014 2020 September 2023

Sources: ECB (ILM) and ECB calculations.

Notes: "Currency' refers to liability item L1; "Central bank reserves" refers to reserve holdings in the current
account and the deposit facility as well as any other liabilities to euro area credit institutions related to monetary
policy operations denominated in euro (L2); "Official sector and other deposits" refers to the sum of liability
items L3, L5 and L6; "Other liabilities" cover all remaining liabilities not included under the labelled categories,
such as revaluation accounts, capital and reserves, and foreign currency liabilities. The latest observations are
for 30 September 2023.

Chart 4
Eurosystem assets

(EUR trillions)
= Total assets tm Monetary policy outright portfolio
tm Credit operations tm@ Gold and FX
tm@ Other assets

0
2002 2008 2014 2020 September 2023

Sources: ECB (ILM) and ECB calculations.

Notes: "Monetary policy outright portfolios" refers to securities of euro area residents denominated in euro held
for monetary policy purposes (A7.1), "Credit operations" refers to lending operations (A5 exceptA5.5 and A5.6),
"Gold and FX' (A1,A2, A3) and "Other assets" (A4, A5.5, A5.6, A6, A7.2, A8, A10, A11) capture the remaining
assets. The latest observations are for 30 September 2023.

Chart 5
Eurosystem credit operations by maturity

(EUR trillions)

Hf 'Short-term' refinancing operations
@ "Medium-term" refinancing operations
"Long-term" refinancing operations

25

20

a ee I

2002 2008 2014 2020 September 2023

Sources: ECB (ILM) and ECB calculations.

Notes: "Short-term' refinancing operations" refers to main refinancing operations (A5.1), "Medium-term'
refinancing operations" refers to to longer-term refinancing operations with original maturity below one year
(part of A5.2), " Long-term' refinancing operations" refers to (targeted) longer-term refinancing operations with
original maturity equal and above one year (remainder of A5.2). The latest observations are for 30 September
2023.

Taken together, Charts 3-5 show that the amount of central bank reserves in the banking system has
expanded substantially. In the first decade of the euro, the ECB had only created reserves to satisfy the
liquidity needs resulting from the demand for banknotes and other so-called autonomous liquidity factors.

[10] in the wake of the GFC, the deployment of some credit operations longer than one year and limited
asset purchases during 2008-2013 led to a moderate expansion in reserves. A more substantial increase
in central bank liquidity occurred from 2015 onwards, reflecting the large-scale implementation of
quantitative easing and targeted lending programmes.

Finally, Chart 6 illustrates the footprint of the Eurosystem in the bond market by scaling asset purchases
to the eligible bond universe. The asset purchases under the SMP, the asset purchase programme (APP)
and the PEPP resulted in a sizeable presence in the bond market, which is now beginning to reverse due
to a combination of the end of APP reinvestments and the ongoing expansion of the bond universe,
especially due to issuance by governments.

Chart 6
Eurosystem bond holdings relative to the eligible bond universe

(percentages)
35

25

20

0
2015 2018 2021 September 2023

Sources: ECB (Eligible Assets Database) and ECB calculations.

Notes: Eurosystem holdings comprise those of the asset purchase programme (APP), pandemic emergency
purchase programme (PEPP) and Securities Markets Programme (SMP). The holdings and universe are
denoted in nominal values. The range of bond maturities included in the eligible universe is from three months
to 30 years. The latest observation is for 30 September 2023.

Central bank reserves: the expansion phase and transitional
dynamics

This section will first review the macroeconomic impact of the sustained expansion of central bank
reserves over 2015-2022. The stock of central bank reserves has been shrinking since autumn 2022 and,
under a wide range of scenarios, is set to continue to shrink over the next few years. In turn, this
transition from peak central bank reserves to the "new normal" steady state also has macroeconomic
implications. The initial experience with the decline in central bank reserves over the last year provides

some preliminary lessons in relation to this transitional phase.

As I set out in the introduction, it is difficult to identify separately the role of central bank reserves and
the impact of asset-side monetary policy measures (quantitative easing, targeted lending). However, it is
plausible that the expansion in central bank reserves has reinforced the impact of quantitative easing
(QE) and targeted lending incentives in easing monetary conditions. In relation to bond purchases, the
portfolio rebalancing incentives faced by banks in adjusting to higher reserve holdings also increases

bank demand for bonds.!4] In relation to credit creation, increased holdings of central bank reserves on a
durable basis provided banks with increased comfort in their liquidity positions and provided incentives to
increase their lending rather than sitting on an excessive amount of cash at the negative short-term

interest rates that prevailed during the period 2014-2022. [12]

The shift in the monetary policy stance that started in December 2021 has provided further evidence on
the role played by central bank reserves in determining macroeconomic outcomes. In particular, the
reduction in central bank reserves from the repayment of TLTRO funds and the end of APP reinvestments
has plausibly contributed to the increase in term premia (Chart 7) and the marked turnaround in credit

dynamics to firms and households (Charts 8 and 9).!43] In the coming years, the ongoing reduction in the
footprint of the ECB in the bond market and the repayment of TLTRO funds can be expected to continue
to put upward pressure on term premia and contribute to lower credit creation. In turn, these
contractionary forces lower the projected paths for GDP and inflation and thereby reduce the level of the
policy rate required to stabilise inflation at the medium-term target (compared to a counterfactual in
which monetary policy tightening was not accompanied by balance sheet reduction). Of course, the total
impact of the decline in central bank reserves depends on the end point of this adjustment process,
which depends on the future steady-state level of central bank reserves. This is the focus of the next
section.

Chart 7
Decomposition of changes in the ten-year nominal overnight index swap rates since
December 2021

(percentages)

@ Expectations component
Term premia component
tm 10-year nominal O1S rate

Dec- 21 Mar-22 Jun-22 Sep-22 Dec-22 Mar-23 Jun-23 Sep-23

Sources: Refinitivand ECB calculations.

Notes: The decomposition of the ten-year spot overnight index swap (OIS) rate into expected rates and term
premium is based on an affine term structure model fitted to the euro area OIS curve. The estimation method
follows Joslin, Singleton and Zhu (2011). The latest observations are for 30 October 2023.

Chart 8

Firm debt financing, credit standards and loan demand

(left panel: average monthly flows in EUR billions for left scale and annual percentage changes for right

scale; middle panel and right panel: net percentages)

wees Other factors
Borrowing from banks

O@ =Net issuance of debt securities
= Total debt financing

Risk perceptions
m= Competition

mw Risk tolerance of banks

v4 Annual growth rate of debt financing (right scale) "=== Credit standards - actual

50 10 40

26

20

-25 6

Q1 2022

Q2 2022

Q3 2022

Q4 2022

Q1 2023

Q2 2023

July 2023

August 2023

September 2023
Q3 2021
Q4 2021
Q1 2022
Q2 2022
Q3 2022
Q4 2022
Q1 2023
Q2 2023
Q3 2023
Q4 2023

Credit standards - expected

I:
30 =

eee Cost of funds and balance sheet constraints

seme Other factors
wees Use of alternative finance
ewes Other financing needs

General level of interest rates

ewes Inventories and working capital
mmm Fixed investment
ee Demand - actual

Demand - expected

Q3 2021
Q4 2021

Q1 2022
Q2 2022
Q3 2022
Q4 2022

om om 2
aa a a
seca
aa a 8
cn oO
Gaga

Sources: ECB (BSI, CSEC, BLS) and ECB calculations.

Notes: The seasonal adjustment for the net issuance of debt securities is not official. Monetary financial
institution (MFI) loans are adjusted for sales, securitisation and cash pooling (left panel). "Other factors" refer to
further factors which were mentioned by banks as having contributed to changes in credit standards (middle
panel). "Other financing needs" calculated as unweighted average of "M&Aand corporate restructuring" and
"debt refinancing/restructuring and renegotiation'; "Use of alternative finance" calculated as unweighted

average of "internal financing", "loans from other banks", "loans from non-banks",

» «

issuance/redemption of debt

securities" and "issuance/redemption of equity' (right panel).The latest observations are for September 2023

(left panel) and for the third quarter of 2023 (middle panel and right panel).

Chart 9
Household loans, credit standards and loan demand

(left panel: average monthly flows in EUR billions for left scale and annual percentage changes for right scale;
middle panel and right panel: net percentages)

wes Other factors memes Other factors
tm Totallending wees Risk tolerance of banks mes Use of alternative finance
Loans for house purchase Risk perceptions eee Other financing needs
® Credit for consumption we Competition General level of interest rates
© Other lending sees Cost of funds and balance sheet constraints - ronsumer canfdence '
"Annual growth rate of total lending (right scale) om Credit standards - actual Demand eet prospect $
Credit standards - expected omen Demand - actual

Demand - expected

30 6 40 80
40
20 4 30
oP a
10 2 20 40 ]
0 0 10 80
120 =

aa ow
a aa
S686 6
a a
= AN
@oag

Q4 2022
Q1 2023
Q2 2023
July 2023
August 2023
September 2023
3
8

a3 2021
a4 2021
at 2022
a2 2022
a3 2022
a4 2022
at 2023
a2 2023
03 2023
042023
a3 2021
42021
a1 2022
a2 2022
a3 2022
42022 Il
at 2023
a2 2023
03 2023
042023

Sources: ECB (BSI, BLS) and ECB calculations.

Notes: MFI loans are adjusted for sales and securitisation (left panel). "Other factors" refer to further factors that
were mentioned by banks as having contributed to changes in credit standards (middle panel). "Other
financing needs" calculated as unweighted average of "M&Aand corporate restructuring" and "debt
refinancing/restructuring and renegotiation"; "Use of alternative finance" calculated as unweighted average of

"internal financing", "loans from other banks", "loans from non-banks'", "issuance/redemption of debt
securities" and "issuance/redemption of equity' (right panel). The latest observations are for September 2023
(left panel) and for the third quarter of 2023 (middle panel and right panel).

Central bank reserves in the steady state

This section will discuss the appropriate steady-state level of central bank reserves and the trade-offs
across the different methods of providing liquidity. It is stipulated that the central bank sets the policy
rate to deliver its medium-term inflation target in the steady state, so that there is no need to turn to
additional instruments (such as QE or targeted refinancing operations) in the steady state. In addition, it
is stipulated that the steady state is characterised by calm financial conditions. At the same time, the
steady state configuration should take into account that the system can be hit by shocks and may
subsequently be driven away from the steady state.

All else equal, the appropriate steady-state level of central bank reserves should be increasing in: the
size of the banking system; the size of the overall financial system; and the overall size of the economy;
the likelihood and potential severity of macro-financial tail events; the scarcity of safe assets; the
effectiveness of micro-prudential and macro-prudential regulations (in combination with supervisory
oversight) in curbing the incentives of banks to engage in excessive balance sheet expansion and
maturity transformation; the mobility of deposits; and the policy prioritisation attached to minimising the

risk of hitting the ELB."4! While this list is non-exhaustive, in working through it, each of these

dimensions clearly also depends on the balance of the asset-side interventions (between refinancing
operations and bond purchases) that are the counterparts to the issuance of central bank reserves 45]

Taking each of these dimensions in turn, the level of central bank reserves should scale up with trend
growth in the size of the banking system and the size of the financial system: the liquidity preference of
investors is likely proportional to the scale of overall asset holdings. In related fashion, all else equal,
autonomous factors such as the desired holdings of banknotes should also trend upwards in line with

overall income levels." tn relation to the banking system, the composition of the assets held by a bank
matters, as does the overall scale of the balance sheet. In particular, a bank may desire to hold central
bank reserves in proportion to the scale of its loan portfolio and its holding of other illiquid assets, since

loans and illiquid assets cannot be costlessly sold in the event of deposit outflows.)

In a system in which the central bank only provides liquidity to banks, the liquidity needs of non-bank
financial institutions (NBFls) can have spillover implications for the banking system.

First, NBFls hold liquidity in the forms of considerable uninsured deposits with banks, together with an
array of highly-liquid market instruments. In particular, if there is a surge in the liquidity needs of NBFls,
due to redemption outflows from investors or rising margin calls on leveraged positions, this would also
intensify liquidity pressures on the banking system through a range of mechanisms.

Next, the prevalence and severity of macro-financial risk increase the prudent level of central bank
reserves. Whereas the long "great moderation" period before the GFC led many to believe that systemic
risks had structurally declined, the sequence of the GFC, the euro area sovereign debt crisis and the
pandemic has powerfully demonstrated that macro-financial risk events can occur and trigger substantial
liquidity demands. Moreover, there is an intrinsic amplification of macro-financial risks in a monetary
union that lacks sufficient area-wide common safe assets and a full banking union, since investors can
try to escape country-specific risks without taking on currency risk by running to safer jurisdictions within
the monetary union. In turn, in view of the scope for self-fulfilling crisis episodes, the likelihood of macro-
financial risk events is intrinsically higher in such a monetary union compared to a complete monetary

union. [48]

Insurance against the liquidity impact of systemic macro-financial risks can also be provided by a central
bank commitment to provide liquidity promptly and elastically during crisis episodes, rather than solely
through the precautionary selfinsurance of holding a high stock of central bank reserves. It follows that
the appropriate ex-ante level of central bank reserves is lower if a central bank has a proven reputation for
the agile expansion of liquidity facilities if stressed conditions emerge.

If safe assets are scarce in the financial system, this can reinforce the value of a higher steady-state

level of central bank reserves if this can deliver a net increase in the stock of safe assets.49 First, all
else equal, the safe asset characteristics of central bank reserves alleviates this scarcity. Second, the
asset-side interventions by central banks to create reserves are less costly if central banks do not
exacerbate safe asset scarcity by exclusively purchasing the highest-rated (or shortest-dated) securities
in a structural bond portfolio. In particular, within limits, some combination of a broad-based structured
bond portfolio and short-term and longer-term refinancing operations against a broad collateral pool can

generate an expansion in the pool of safe assets, without excessively crowding out other purchasers of
the highest-quality bonds.

As shown in the previous section a high stock of central bank reserves may support credit creation, at
least if banks are confident that these will remain available for a significant period, rather than requiring

frequent rollover.!22 if there are frictions in credit intermediation, this boost to credit creation might be
welcomed as bringing the economy closer to the social optimum. In contrast, if the banking system is
characterised by distorted incentives to over-lend and take excessive risks, the boost to credit creation
could rather be viewed as a negative and would call for a lower stock of central bank reserves. It follows
that the regulatory and supernisory environment is a pivotal factor in determining the prudent level of
central bank reserves. In particular, a regulatory system (backed up by effective supervision) that curbs
over-lending and distorted incentives to take excessive risks would mitigate concerns that a high level of
central bank reserves might overly stimulate credit creation. This spans micro-prudential regulations
(including capital requirements and leverage requirements), macro-prudential regulations (including
borrower-based measures and counter-cyclical and systemic risk buffers) and close supervisory

monitoring of the risk management practices in the banking system. 24)

In related manner, a high stock of central bank reserves can act to lower term premia in bond markets for
two reasons. First, if central bank reserves are created via bond purchases by the central bank, this

directly lowers term premia by extracting duration risk and credit risk.!22] Second, even if created via
refinancing operations, banks may boost their bond holdings as a balanced portfolio response to higher

reserves.!25] To the extent that market frictions (including, in an incomplete monetary union, the risk of
self-fulfilling, unwarranted market fragmentation events) excessively depress bond market participation,
the curbing of excessive term premia might be viewed as a positive feature by underpinning financial
stability.

In the other direction, if term premia are excessively compressed, this generates undesirable financial

stability risks through search-for-yield-behaviour and asset mispricing.!24] Comprehensive financial
regulation and supervision (of both banks and non-bank financial institutions) can mitigate such risks to
some extent. Further possible mitigants include: the omission of the longest maturities from the steady-
state structural bond portfolio of the central bank; the prioritisation of supranational bonds over national
bonds; and the inclusion of private sector bonds in addition to sovereign bonds. In any event, the
calibration of the appropriate steady-state level of central bank reserves must balance the competing pro-
stability and anti-stability effects on the financial system of a high stock of central bank reserves.

Limiting the excessive compression of term premia also calls a sufficient role for refinancing operations in
the creation of central bank reserves, rather than building an excessively-large structural bond portfolio. In
addition, refinancing operations also promise to have a more even distribution of reserves across
individual banks, since the proceeds of asset purchases tend to be deposited (and remain pooled) in a
relatively small number of "money centre" banks, whereas all banks have access to refinancing
operations (subject to collateral availability)./25] From a macroeconomic perspective, the attractiveness of
using both a structural portfolio and refinancing operations to generate reserves is that this is more
efficient in getting liquidity into all the cracks (across different types of banks and across jurisdictions),
which is plausibly not the case if reserves are only created through a structural bond portfolio and there

are frictions to the mobility of reserves. Cross-border frictions are a particular concern in a limited
monetary union (that lacks a complete banking union and capital markets union). Of course, frictions
across different types of bank business models are also present even in fully-integrated financial
systems.

In turn, there are distinct possible roles for short-term (one-week) refinancing operations and longer-term
(say, one year or longer) refinancing operations. Short-term refinancing operations have traditionally been
a standard, flexible tool to manage fluctuations in the liquidity needs of banks. However, an over-reliance
on short-term refinancing poses operational risk challenges, while investors and regulators may prefer
banks to have a healthy proportion of longer-term refinancing in the overall liquidity profile. Moreover, from
a macroeconomic perspective, seven-day funding does not necessarily provide sufficiently-durable
liquidity to support longer-term commitments such as bank loans or the acquisition of illiquid assets.
Furthermore, in principle, structural longer-term refinancing operations could remedy some specific credit
intermediation frictions such as the possible under-funding of investment projects to underpin the green

transition that typically demand stable funding over a longer horizon. !26]

Another factor calling for more reserve holdings is the extent to which deposits are mobile. Along one
dimension, the sectoral composition of deposits matters: deposits from households and firms are stickier
than deposits from non-bank financial institutions. In terms of the geographical dimension, in an
incomplete monetary union, there is a high potential degree of cross-border deposit mobility under
stressed conditions. Such geographical flight-to-safety deposit dynamics can be amplified if there is
excessive reliance on refinancing operations as a source of liquidity, since the value of the local collateral
available would fall under stressed conditions, giving rise to liquidity spiral dynamics by which lower
liquidity interacts with falling asset values.

Finally, the appropriate steady-state level of central bank reserves depends on the policy prioritisation
accorded to avoiding the effective lower bound on the policy rate. To the extent that a larger stock of
central bank reserves supports more credit creation and lower term premia, the equilibrium policy rate
will have to be higher (and further away from the ELB) in order to deliver the inflation target. This
preserves policy space, since the extra distance to the ELB would in turn facilitate the deployment of
rate cuts in the event of dis-inflationary shocks. However, this concern is less important if it is understood
that the central bank would not hesitate to roll out quantitative easing and targeted lending programmes if

the ELB constrained policy rate cuts.24

Conclusion

Let me draw some conclusions on the macroeconomics of central bank reserves. First, even if much
lower than the current level, the appropriate level of central bank reserves in the "new normal" steady
state should avoid the risks associated with excessively-scarce or excessively-abundant reserves. Such
a middle path would strike an appropriate balance between the benefits and costs associated with the
creation of central bank reserves and also seems best suited to safeguard the stability of the banking
and financial systems.

In particular, a durable level of central bank reserves is likely required to ensure the sufficient provision of
bank credit to enable the euro area economy to attain its steady-state potential output growth rate, in

view of the importance of central bank reserves in underpinning the willingness of banks to extend credit
in spite of the risks associated with illiquid assets (Such as bank loans) in a world much more prone to
macro-financial shocks. This steady-state level of central bank reserves likely has a positive trend
component, in view of the connection between the optimal level of central bank reserves and the overall
size of the financial system.

Second, in view of the trade-offs posed by each individual instrument, it seems proportionate from a
macroeconomic perspective for a central bank to use a range of instruments to provide central bank
reserves. Central bank reserves can be provided both through a structural bond portfolio on the one side,
and a structural longer-term refinancing operation as well as a standard short-term refinancing operation
on the other side. A mix of a structural bond portfolio and longer-term refinancing operations would
provide longer-time liquidity to the banking system, while the short-term refinancing operations are well
suited to the absorption of h