SPEECH

The analytics of the monetary policy tightening
cycle

Guest lecture by Philip R. Lane, Member of the Executive Board of
the ECB, at Stanford Graduate School of Business
Stanford, 2 May 2024

Introduction

My aim today is to review the ECB's monetary policy tightening cycle. The tightening began in
December 2021 with the announcement of the end date for our net purchases under the pandemic
emergency purchase programme (PEPP), as well as the recalibration and subsequent phase-out of
our targeted lending programme. After concluding net purchases under the PEPP in March 2022 and
net purchases under the asset purchase programme (APP) in June 2022, we subsequently normalised
our policy rate (the deposit facility rate [DFR] in conditions of abundant excess liquidity) from -0.5 per
cent to 2 per cent in the second half of 2022, before raising rates further into restrictive territory during
the first nine months of 2023 to a level of 4.0 per cent. We have held the DFR constant at this level

over the last five meetings since our last hike in September (Chart 1).!2]

This was an especially striking tightening campaign in view of the prevailing highly-accommodative
monetary stance, which consisted of very low levels of the policy rate that had been in place over the
last decade, the considerable net asset purchasing under the APP since 2015 and under the PEPP
since 2020 and the scale and pricing of the targeted long-term refinancing operations. In late 2021,
this stance was still expected to be maintained over the medium term: for instance, the median
respondent in the December 2021 Survey of Monetary Analysts expected the deposit facility rate to
remain in negative territory until the first quarter of 2025 and net purchases under the APP to continue
until June 2023. It follows that, relative the path expected in late 2021, the tightening cycle constituted
a major surprise. Of course, the underlying driving force for the tightening cycle was the very large
surprise increase in inflation, especially in 2022, after the unjustified Russian invasion of Ukraine. A
defining feature is that a significant component of the stance tightening is expected to be persistent in
nature, with rates only expected to descend to the neighbourhood of a more neutral level, while

quantitative easing and targeted refinancing operations are not expected to be resumed.

Chart 1: Policy rate path and risk-free curve over time

(percentages per annum)

Realised deposit facility rate === December 2021 mmm March 2022 mmm July 2022 meme December 2022 -_-_--£ February 2024 -_-<€ April 2024

2022 2023 2024 2025 2026 2027

Sources: Bloomberg and ECB calculations.

Notes: The cut-off dates for the data used for the €STR forward curves are 17 December 2021, 11 March 2022,
22 July 2022, 16 December 2022, 9 February 2024, and 29 April 2024.

The aim of this lecture is to review this tightening cycle from an analytical perspective. The tightening
cycle had two basic aims. First, during an extended period in which inflation was far above our target,
it was imperative to unwind a monetary stance that would have been too accommodative relative to
the rapid shift in expected inflation over the relevant policy horizon. Second, given the scale of the
surprise inflation in 2021-2022, it was essential to contain the propagation of the inflation shock
through the subsequent price-wage adjustment phases. While corrective waves of price and wage
resetting were inescapable, a monetary stance that ensured that demand would be dampened and
that inflation would return to the target in a timely manner would be needed to ensure an orderly
adjustment phase that did not risk embedding above-target inflation into longer-term inflation
expectations.

In calibrating the speed and scale of monetary tightening in the context of the post-pandemic recovery
and extraordinary surge in energy prices (including due to the Russian invasion of Ukraine), several
considerations were paramount.

First, lags in monetary transmission were inevitable: it would take time for monetary policy to exert its
full impact on inflation.

Second, the descent of inflation from its peak would be assisted by the reversal of some of the factors
driving the inflation surge: the easing of supply bottlenecks; the likely expansion of energy supply and
contraction in energy demand in response to the spectacular increases in oil and gas prices; and the
gradual re-normalisation of the economy through the fading out of pandemic-related distortions in
sectoral supply and demand patterns. That is, the calibration of monetary policy should take account
the temporary nature of some of the shocks, while making sure that these temporary shocks would not
convert into permanent inflation through the de-anchoring of inflation expectations.

Third, the calibration needed to allow for various types of uncertainty. Along one dimension, there was
uncertainty about the intrinsic persistence of the inflation process. In addition to the standard
uncertainty about the feedback dynamics by which price increases in one period would trigger
subsequent price and wage increases in following periods, the scale of inflation during 2022 also led to
shifts in behaviour, with firms switching to more frequent pricing resets. While this added to the
intensity of inflation, it also held out the possibility that the overall adjustment process could be front-

loaded.!2] Ultimately, the persistence of inflation would turn on the scale of de-anchoring of inflation
expectations, which warranted close monitoring.

Along a second dimension, there was uncertainty about the strength of transmission of monetary
policy in view of possible shifts in the economic, financial and monetary environment. First and
foremost, the many years of low inflation and the strategic commitment by central banks to deliver the
inflation target over the medium term provided a strong foundation for containing the inflation shock,
compared to the costly de-anchoring dynamics observed in the 1970s. Compared to previous
tightening cycles, it was also important to take into account trend shifts in: the sectoral composition of
activity (which, among other things, can affect the overall degree of price rigidity in the economy, the
interest sensitivity of demand and the overall sensitivity of activity levels to domestic demand); the
state of the labour market; the scale of leverage among households and firms; the state of the banking
system (which had been stabilised following regulatory reforms and intensified supervision with the
introduction of the Single Supervisory Mechanism) in relation to capital levels, the risk profiles of loan
books (including due to the beneficial impact of borrower-based macroprudential measures) and bond
holdings, together with the risk profile of liability structures; and, finally, structural exposures to interest

rate movements (with a substantial increase in the share of fixed-rate mortgages)./4]

In addition to trend shifts, the pandemic itself had resulted in lower leverage and more robust balance
sheets, due to forced savings during the pandemic and the scale of fiscal transfers to households and
firms. Furthermore, monetary tightening could be taking hold at the same time as a projected rebound
in economic activity might protect employment levels, with firms holding onto workers in anticipation of
post-pandemic normalisation. Working in the opposite direction, Russia's unjustified war against
Ukraine had triggered a major increase in economic uncertainty, while the surge in imported energy
prices constituted a major terms of trade shock that substantially reduced real incomes and purchasing
power: these forces were independently likely to dampen consumption and investment for any given

level of monetary restriction.

Along a third dimension, the nature of the monetary configuration also created uncertainty about the
tightening process. After many years of expanding the central bank balance sheet (which had further
accelerated during the pandemic), the required shift in the monetary stance called for an exit from net
asset purchases and a pull back from the longer-term refinancing operations that had pumped liquidity
into the banking system, in addition to the lifting of the policy rate. In the absence of historical
benchmarks for this exit process, there was a wide range of views about the possible impact on the
financial system. In addition, since both balance sheet normalisation and the lifting of policy rates were
simultaneously proceeding at a global level, there was also uncertainty about the strength of

international spillovers in the tightening process. !5]

A final uncertainty dimension related to the modelling of monetary policy. The ECB maintains a suite of

macroeconomic models in order to provide robust underpinnings for forecasting and policy analysis.
The projected impact of shifts in monetary policy varies across these models, in line with differences in
the specification of the economic and financial environment and, crucially, in the sensitivity of inflation
expectations to policy actions.

Taken together, these various types of uncertainty underlined the importance of taking a data-
dependent approach to the calibration of monetary policy that would take into account the evolving
inflation outlook, the realised path for underlying inflation indicators and the incoming evidence on the
strength of monetary policy transmission.

I will now provide an analytical review of the transmission of monetary policy tightening to: the financial
and banking systems; the economy; and, finally, inflation. I will also briefly draw some lessons from the
tightening period for the conduct of monetary policy during the next phase of the cycle.

Transmission to financial markets and the banking sector
Our policy rate hikes and the phasing out of asset purchases have been passed smoothly to money

markets, risk-free rates, risk assets and lending rates by banks]

Transmission via market interest rates

The money market is the immediate locus in the transmission of monetary policy. Our key ECB interest
rates have a direct impact on the rates prevailing in that market, while our balance sheet policies also
play an important role. The transmission of the steep increase in our policy rates to unsecured money
market rates has been smooth and complete. This is essential for a proper transmission as the euro
short-term rate (ESTR) and expectations about its future path form the basis of the entire euro area
risk-free rate curve: the overnight index swap (OIS) rates. In the secured money market, rates saw
some imperfect pass-through in late 2022 as the revaluation of bonds contributed to a temporary
scarcity of collateral. Our measures (such as securities lending, cash collateral, and changed
remuneration of government deposits) have helped to successfully restore full transmission in that part
of the money market as well.

As we returned to our policy rates as the primary instruments for steering the monetary policy stance
in 2022, the understanding in the market of how we decide the key ECB interest rates has become
pivotal again. This understanding contributes to the formation of expectations of market participants
about the future path of interest rates and thereby has an immediate impact on medium- to longer-term
interest rates, which are particularly consequential for the economy. ECB staff analysis of euro area
risk-free rates and inflation-linked swap (ILS) rates suggests that financial markets have rapidly
internalised the ECB's pattern of reaction to changes in the inflation outlook. As a result, the gradual
upward shift of the €STR forward curve throughout the tightening cycle (Chart 1) was more than
proportional to the upward shift in market-based measures of inflation compensation (Chart 2),
bringing real interest rates in the euro area from deeply negative to firmly positive levels.

Chart 2: Inflation path and fixings

(percentages per annum)

tm Realised HICP tm Fixings - October 2022 Governing Council meeting
w= Fixings - December 2021 Governing Council meeting = Fixings - Latest
== Fixings - April 2022 Governing Council meeting

12

10

8

2020 2021 2022 2023 2024 2025 2026 2027

Sources: Bloomberg, LSEG and ECB calculations.
Notes: "Latest" refers to fixings with a cut-off date of 29 April 2024. The latest observations are for March 2024 for
realised HICP (monthly data).

When annual HICP inflation stood at 5 per cent in December 2021, markets were still pricing in a
steady return of inflation to 2 per cent by the end of 2022. The repeated upward surprises in inflation
thereafter caused an upward repricing of risk-free rates and of measures of inflation compensation, yet
without signs that markets were misrepresenting our reaction function or that they were expecting
inflation to stay permanently high. In fact, the inflation path priced into measures of inflation
compensation and ECB staff analysis that seeks to extract the genuine inflation expectations
component indicate that longer-term inflation expectations have remained well anchored close to 2 per
cent throughout this episode.

The continued anchoring of inflation expectations also helps explain another pattern in euro risk-free
rates that has caused concerns among some observers: the slope of the risk-free curve - as
measured by the difference between the OIS-ILS spread at a ten-year compared to two-year maturity
- has been negative for over a year now and even stood at -0.8 in June 2023, a record-low level since
the launch of the euro (Chart 3). Historically in the euro area and elsewhere, an inverted yield curve

has often preceded economic recessions. While the euro area economy has been stagnating, fears
of a deep and long recession have proven unfounded. At the current juncture, the negative slope of the
yield curve points to an assessment by markets which is directionally in line with ours: short-term
interest rates stand at high and firmly restrictive levels but medium to longer-term rates are lower, as
inflation and with it our policy rates are set to decline over time. In other words, the current inversion of
the yield curve indicates expectations of an eventual normalisation of inflation towards 2 per cent and

of interest rates towards more neutral levels.

Chart 3: Slope of the risk-free yield curves

(percentages per annum)

= 1Dy-2y
Euro area recession

-3
1972 1982 1992 2002 2012 2022 Mar-24

Sources: Bloomberg and ECB calculations.

Notes: Pre-1999 OIS rates are extrapolated using German Bund yields. Shaded areas indicate periods of euro
area recession as defined by the CEPR-EABCN Euro Area Business Cycle Dating Committee. The latest
observations are for March 2024 (monthly data).

Longer-term risk-free rates increased in the euro area not only on account of higher expected policy
rates, but also due to other measures taken by us and central banks globally. In particular, the phasing
out of asset purchases has had an additional tightening effect via the decompression of term premia.
Since December 2021, more than one third of the 280 basis point increase in the ten-year euro area
OIS rate is estimated by our staff to result from an increase in term premia stemming from quantitative
tightening and other factors. Indeed, the ongoing reduction (both realised and expected) of the
Eurosystem bond holdings has been the main driver behind the increase in sovereign risk premia -
and, given the no-arbitrage condition, in risk-free term premia - as duration risk is added back into the
market (Chart 4).

Chart 4: Impact of APP and PEPP sovereign bonds holdings on sovereign risk premia
of the big-4

(basis points)

-200
2015 2016 2017 2018 2019 2020 2021 2022 2023 Mar-24

Sources: ECB calculations.

Notes: The chart shows the estimated impact of APP and PEPP holdings on the GDP-weighted sovereign risk
premium of sovereign bonds for the big-four sovereign issuers (Germany, France, Italy and Spain). Impacts are
derived on the basis of an arbitrage-free affine model of the term structure with a quantity factor (see Eser, F.,
Lemke, W., Nyholm, K., Radde, S. and Vladu, A. L. (2023), "Tracing the Impact of the ECB's Asset Purchase
Program on the Yield Curve", International Journal of Central Banking). The upper range of the blue area, i.e. the
smaller impact estimates are based on the baseline version of the model, while the lower range of the blue area,
i.e. the greater impact series are based on an alternative version of the model informed by the yield reactions to
the March 2020 PEPP announcement. The latest observations are for March 2024.

Our policy tightening has also been reflected in sovereign bond markets, which have coped well with
the rapid increase in interest rates. Sovereign bonds serve as a key reference asset to price other
bonds and as an important determinant of overall financial conditions within economies. ECB staff
analysis also confirms that sovereign stress impairs the transmission of monetary policy to the real
economy and eventually to inflation. Looking at the euro area as a whole, GDP-weighted euro area
sovereign bond yields have moved largely in lockstep with risk-free rates in recent years. As a result,
the ten-year yield spread over the OIS rate has been fairly stable (Chart 5). While the increase in
interest rates and the decline of the Eurosystem balance sheet have induced upward pressure on
longer-term bond yields, the pandemic emergency purchase programme (PEPP), including the in-built
flexibility applied to reinvestments, and the transmission protection instrument (TP!) have been
important elements in our monetary toolkit. It is plausible that the remarkably smooth transmission of
the forceful tightening cycle to the sovereign bond market would not have been possible to the same
extent without PEPP flexibility and the TPI. The EU-wide solidarity embodied in the NGEU programme

has also played a vital role in reducing risk premia.

Chart 5: Ten-year sovereign yield spreads over OIS rates

(percentages per annum)

= Germany = Spain
we) France "= Euro area (GDP-weighted)
= Italy

2020 2021 2022 2023 2024 «23 Apr

Sources: Refinitiv and ECB calculations.

Notes: The spread is the difference between individual countries' ten-year sovereign yields and the ten-year OIS
rate. The latest observations are for 29 April 2024.

Finally, the exchange rate response has been relatively muted over the tightening cycle. The euro has
remained broadly stable against the US dollar(Chart 6). This is largely due to the considerable degree
of synchronicity of the tightening cycle.

Chart 6: USD/EUR exchange rate and EA-US 2-year interest rate differential (based
on OIS rates)

(left-hand scale: USD/EUR, right-hand scale: percentage points)

== USD/EUR
= Difference in2 year interest rate (rhs)
1.25 as
1.20 0.0
1.15 0.5
1.10 40
1.05 18
1.00 20
0.95 25
0.90 -3.0
Jan-19 Jul-19 Jan-20 Jul-20 Jan-21 Jul-21 Jan-22 Jul-22 Jan-23 Jul-23 Jan-24 25-Apr-24

Sources: Bloomberg, ECB and ECB staff calculations.

Notes: The latest observations are for 25 April 2024.

Transmission via the banking sector

The transmission of the restrictive monetary policy stance to bank lending conditions has evolved over
the course of the tightening cycle. In general, the cost of funding for banks depends both on their
sources of funding and the term structure of interest rates. Bank bond yields responded quickly to the
tightening monetary policy (Chart 7). And while the pass-through from our policy rates to the average
rates that banks apply to deposits has been partial and relatively slow, time deposit rates, especially
those of firms, have tracked policy rate hikes rather closely (Chart 8).

One contributor to the asymmetry in the response of returns on different segments of bank funding to
monetary policy was that banks had been reluctant to pass on negative interest rates to their retail
depositors during the highly accommodative phase, driving a negative spread between the
remuneration of customer deposits and the interest banks were receiving on reserves. As a corollary,
banks were initially slow to raise deposit rates in order to restore traditional margins. In addition, the
high amount of central bank liquidity and the low demand for credit also limited the pressure to
increase deposit rates. Furthermore, a lack of competition in some member countries also reduced the
pass through to deposit rates.

Over the period since September 2023 in which we have held our policy rates constant, bank bond
yields have declined somewhat, in part reflecting the anticipation of future rate cuts, while deposit rates
have continued to increase, as competition for deposits intensifies and depositors shift funds from
lower remuneration overnight deposits towards more attractive time deposits.

Chart 7: Bank funding costs

(percentages per annum)

eee Bank bond yields = Bank bonds
w= Deposit rates Savings deposits
= Composite bank funding costs = Overnight deposits
5 Level a5 Change since December 2021

Sources: ECB (BSI, MIR, FM), Markit iBoxx and ECB calculations.

Notes: The chart shows daily bank bond yields. Monthly new business deposit rates are weighted by outstanding
amounts. Composite funding costs are a weighted average of deposit rates and average monthly bond yields, with
outstanding amounts as weights. Right panel shows the contributions of the components to the change in the
composite bank funding cost between December 2021 and February 2024. The latest observations are for
February 2024 for monthly data and 17 April 2024 for daily data.

Chart 8: Deposit rates

(percentages per annum)

me ECB policy rate ere Time deposits up to two years om Overnight deposits
5 Firms 5 Households
4 4
a a
2 2
1 1
Oo 0
1 1
Jan-22 Oct-22 Jul23 Feb-24 Jan-22 Oct-22 Jul23 Feb-24

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

Notes: Time deposits refer to deposits with agreed maturity of up to two years; shaded areas show ranges across
Germany, Spain, France and Italy. The latest observations are for February 2024.

Banks have passed on their increased funding costs to firms and, to a slightly lesser extent,
households in mortgage lending (Chart 9). Interest rates on new lending increased rapidly, peaking
soon after the last rate hike in September 2023, but have been edging down recently. However,
average lending rates on the outstanding stock of loans have continued to increase. This reflects the

ongoing transmission of past rate hikes, as loans that were granted in the past at lower rates reprice.

Chart 9: Bank lending rates to households and firms

(percentages per annum)

= New business
Outstanding arnounts

Firms Households for house purchase
6 6
5 5
4 4
Kc) a
2 2
1 1
Jan-20 Jan-22 Feb-24 Jan-20 dan-22 Feb-24

Source: ECB (MIR) and ECB calculations.

Note: Interest rates on new business for firms and households for house purchase refer to the indicator for the
total cost of borrowing, which is calculated by aggregating short-term and long-term rates on new business using
a 24-month moving average of new business volumes. The latest observations are for February 2024.

The annual growth rate of lending to firms and households declined sharply over the tightening cycle
but is now also showing signs of stabilisation, albeit at low levels. According to the most recent bank
lending survey (BLS), net demand for new bank loans by firms is still declining, as the high interest
rate environment keeps external financing costs elevated and the weak growth environment means
that firms are postponing fixed investment plans (Chart 10). At the same time, banks reported a
modest net tightening of bank credit standards for loans to firms, mainly on account of increased risk
perception (Chart 11)

Evidence from the survey on the access to finance of enterprises (SAFE) is consistent with the
weakness in bank lending to firms (Chart 12 and Chart 13). Firms participating in SAFE have reported
a continued deterioration in bank loan availability, although this has eased from previous rounds and
firms do expect a small improvement in credit supply over the next three months. There has also been
a sharp drop in the share of firms applying for a bank loan, a continuation of the trend that began late
last year. At the same time, firms signalled less reliance on bank loans, which might reflect sufficient
internal funds and/or easier access to non-bank external funding, together with the postponement of
investment plans due to a slowing economy or expectations of lower interest rates later this year.

Turning to lending conditions to households, the BLS results point to tentative stabilisation in net
demand for new loans to households, while credit standards on household mortgages eased for the
first time in two years (Chart 14 and Chart 15). Taken together, the information from these surveys is
consistent with persistently-weak credit demand and stabilisation in credit supply conditions to firms
and households at tight levels.

Chart 10: Change in demand for loans to firms, and contributing factors

(net percentages of banks reporting an increase)

mes Other factors ues Use of alternative finance
jms Other financing needs men General level of interest rates
(ue Inventories and working capital jee Fixed investment
er Actual demand Expected demand
60
40
20
0
-20
-40
-60
-80
-100

Q1 2022 Q2 2022 Q3 2022 Q4 2022 Q12023 Q2 2023 Q3 2023 Q4 2023 Q1 2024 Q2 2024

Source: ECB (BLS).

Notes: "Other financing needs" is the unweighted average of "mergers/acquisitions and corporate restructuring"
and "debt refinancing/restructuring and renegotiation". "Use of alternative finance" is the unweighted average of
"internal financing", "loans from other banks", "loans from non-banks", "issuance/redemption of debt securities"
and "issuance/redemption of equity". The net percentages for "Other factors" refer to an average of the further
factors which were mentioned by banks as having contributed to changes in loan demand. The latest observations

are for the first quarter of 2024.

Chart 11: Change in credit standards for loans to firms, and contributing factors

(net percentages of banks reporting a tightening)

= Cost of funds and balance sheet constraints =e Competition
samme Risk perceptions mmm Risk tolerance
jee Other factors -e Actual credit standards

Expected credit standards

Q1 2022 Q2 2022 Q3 2022 Q4 2022 Q1 2023 Q2 2023 Q3 2023 Q4 2023 Q1 2024 Q2 2024

Source: ECB (BLS).
Notes: "Cost of funds and balance sheet constraints" is the unweighted average of "banks' capital and the costs

related to banks' capital position', "access to market financing" and "liquidity position". "Risk perceptions" is the
unweighted average of "general economic situation and outlook", "industry or firm-specific situation and
outlook/borrower's creditworthiness" and "risk related to the collateral demanded". "Competition" is the unweighted
average of "competition from other banks", "competition from non-banks" and "competition from market financing".
The net percentages for "Other factors" refer to an average of the further factors which were mentioned by banks

as having contributed to changes in credit standards. The latest observations are for the first quarter of 2024.

Chart 12: Credit supply and loan availability of firms

(net percentages)

= Creditstandards (BLS) @ Expected credit standards (BLS)
40 = Bank loan availability, inverted (SAFE) @ Expected bank loan availability, inverted (SAFE)
30
20
10
e
0
o
-10
-20
Q2 2010 Q2 2012 Q2 2014 Q2 2016 Q2 2018 Q2 2020 Q2 2022 Q2 2024

Source: ECB (BLS and SAFE).

Notes: For the BLS a positive value is a net tightening of credit standards. For the SAFE a positive value is a net
decrease in bank loan availability. SAFE figures are inverted. The circles refer to expectations over the next three
months.

Chart 13: Loan demand, bank loan applications and financing needs

(left-hand scale: net percentages; right-hand scale: percentages)

= Net increase in demand forloans, BLS (left-hand scale)
= Net increase in financing needs for loans, SAFE (left-hand scale)
== Percentage share of loan applications, SAFE (right-hand scale)

75 50
50 40
v3} 2
0 2
25 10
50 0
Q2 2010 Q2 2012 Q2 2014 Q2 2016 Q2 2018 Q2 2020 Q2 2022 Q1 2024

Source: ECB (BLS and SAFE).

Notes: On the left-hand scale, for the BLS, a positive value is a net increase in loan demand at the bank; for the
SAFE, a positive value is a net increase in the need of firms for bank loans. On the right-hand scale, the
percentages shown are for firms that applied for a bank loan relative to firms for which bank loans are a relevant
source of finance. The latest observations are for the first quarter of 2024.

Chart 14: Change in demand for loans to households for house purchase, and

contributing factors

(net percentages of banks reporting an increase)

ees Housing market prospects (eee Consumer confidence
= General level of interest rates wummees Other financing needs
"mmm Use of alternative finance wes Other factors

== Actual demand

Expected demand
50

-50

-100

-150

-200
Q1 2022 Q2 2022 Q3 2022 Q4 2022 Q1 2023 Q2 2023 Q3 2023 Q4 2023 Q1 2024 Q2 2024

Source: ECB (BLS).

Notes: "Other financing needs" is the unweighted average of "debt refinancing/restructuring and renegotiation"
and "regulatory and fiscal regime of housing markets". "Use of alternative finance" is the unweighted average of
"internal finance of house purchase out of savings/down payment", "loans from other banks" and "other sources of
external finance". The net percentages for "Other factors" refer to an average of the further factors which were
mentioned by banks as having contributed to changes in loan demand. The latest observations are for the first
quarter of 2024.

Chart 15: Change in credit standards for loans to households for house purchase,

and contributing factors

(net percentages of banks reporting a tightening)

"umes Cost of funds and balance sheet constraints =e Competition
mmm Risk perceptions was Risk tolerance
jm Other factors -- Actual credit standards

Expected credit standards

40

30

20

10

-10
Q1 2022 Q2 2022 Q3 2022 Q4 2022 Q1 2023 Q2 2023 Q3 2023 Q4 2023 Q1 2024 Q2 2024

Source: ECB (BLS).
Notes: "Cost of funds and balance sheet constraints" is the unweighted average of "banks' capital and the costs

related to banks' capital position', "access to market financing" and "liquidity position'; "Risk perceptions" is the
unweighted average of "general economic situation and outlook", "housing market prospects, including expected
house price developments" and "borrower's creditworthiness". "Competition" is the unweighted average of
"competition from other banks" and "competition from non-banks". The net percentages for "Other factors" refer to
an average of the further factors which were mentioned by banks as having contributed to changes in credit
standards. The latest observations are for the first quarter of 2024.

In comparison to previous hiking cycles, the flow of credit to firms has declined more quickly since the
start of our policy rate hikes (Chart 16). The decline in credit observed so far in the current cycle has
been stronger than historical regularities would suggest, based on linear models. The particularly large
and rapid increase in policy rates may have amplified the tightening impulse. This may have activated
two specific amplification channels operating through bank and firm balance sheets. The first is a risk-
taking channel, in which large policy rate hikes increase the riskiness of borrowers, reducing the

capacity and willingness to lend. The second is a signalling channel, through which rapid rate hikes
might foreshadow a deterioration in future economic conditions, reducing the expected revenues and
increasing the expected future funding costs of potential borrowers, leading them to reduce their
demand for credit. Staff estimates suggest that the actual contraction in credit has been more in line
with a path that incorporates such non-linear effects in transmission operating through bank and firm
balance sheets (Chart 17).

The availability of liquidity to the banking system is also playing a role in the transmission to bank
lending. Estimates by ECB staff suggest that banks with lower excess liquidity are more likely to
reduce their supply of credit in response to policy rate hikes, and the increase in their lending rates is
likely to be larger (Chart 18). This means that, as aggregate liquidity shrinks, the transmission of our
restrictive monetary policy stance to bank lending may strengthen.

Finally, institutional factors, such as banking supervision and macroprud