ECB’s Lane: Closely Monitoring OIS Rates and Sovereign Yields

25 February 2021

By David Barwick – FRANKFURT (Econostream) – In addition to the conditions applied by banks to firms and households wishing credit, risk-free overnight index swap rates and sovereign yields are a ‘particularly important’ indicator of financing conditions’ favourability that the European Central Bank is ‘closely monitoring’, ECB Executive Board member Philip Lane said on Thursday.

In a speech at Comissão do Mercado de Valores Mobiliários posted to the ECB’s website, Lane, who is also chief economist, said that bond buys made under the pandemic emergency purchase programme (PEPP) would be ‘conducted to preserve favourable financing conditions over the pandemic period.’

‘We will purchase flexibly according to market conditions and with a view to preventing a tightening of financing conditions that is inconsistent with countering the downward impact of the pandemic on the projected path of inflation’, he added.

However, this is ‘only the first stage of what monetary policy needs to accomplish’, he said, which is why the ECB ‘will need to continue providing ample monetary accommodation for an extended period, even after the disinflationary pressures caused by the pandemic have been sufficiently offset.’

The fallout from the pandemic continues to threaten the inflation outlook, he said.

As the coronavirus is contained, there should be a ‘significant expansion later this year’ and into next, he said. Still, ‘significant policy interventions’ will be called for to ensure a recovery that in turn underpins stronger inflation, he said.

This is ‘the basic rationale’ behind ensuring favourable financing conditions as ‘a necessary intermediate target’ en route to price stability, he said.

The ECB’s promise to preserve favourable financing conditions helps avoid any undue tightening that could occur in the context of better economic prospects, ‘as markets factor in the reaction of the ECB’, he said.

Determining the required degree of favourability implies the need ‘to employ a holistic and multi-faceted approach and examine financing conditions for the whole economy’, he said. That is, he elaborated, it requires the consideration of ‘a broad spectrum of indicators covering the entire transmission chain’ in the context of a ‘granular approach, such that each indicator provides a valuable signal on a specific segment of the transmission process.’

These indicators need to extend from what Lane called ‘upstream stages’ that are ‘steered by the risk-free and sovereign yield curves’ to ‘downstream effects, where financing conditions are defined by the cost and volume of external finance available to the firms and households that are dependent on banks for access to credit.’

In the latter context of bank-based financing conditions, Lane observed that the ECB’s Bank Lending Survey had indicated a ‘broad-based tightening in credit conditions’. This tightening ‘signals potential risks to future loan growth’, he said. At the same time, the downsizing of investment intentions ‘has been an important source of the decline in credit demand’, he said.

Policymakers must avert an adverse feedback loop between banks that ‘perceive the dwindling loan demand as a negative signal about the state of the economy’ and companies that take the tightening of credit conditions as confirmation of their concerns regarding macroeconomic prospects, he said. A weakening of household spending would lead to further deterioration, he noted.

Besides directly supporting financing conditions downstream via refinancing operations like the ECB’s targeted longer-term refinancing operations (TLTROs), ensuring financing conditions also supports bank lending, thus preventing adverse feedback loops, he said.

‘These upstream-downstream inter-connections underline the critical importance of market-based financing conditions for the entire economy, not just for those entities that directly raise funding in the capital markets’, he said.

As for market-based financing conditions, he said, the most relevant yield curves in Europe are the OIS curve, which he called ‘a proxy for a risk-free curve in the euro area’, and the GDP-weighted sovereign bond yield curve.

Keeping the risk-free yield curve at highly accommodative levels is a necessary but not a sufficient condition for financing conditions overall to be ‘supportive enough to counter the negative pandemic shock to the projected inflation path’, he said.

It is also necessary that movements of the risk-free curve be reflected in benchmark rates important for pricing financial instruments and bank credit, he continued. This role is played by the sovereign bond yield curve, as these yields serve as a basis for pricing corporate and bank bonds as well as bank loans to firms and households, he said.

The OIS yield curve and the GDP-weighted sovereign yield curve thus ‘play fundamental roles in the transmission of monetary policy and deserve particular attention within a holistic and multi-faceted approach to monitoring financing conditions’, he said.

An assessment of the yield curves at a given moment should be with respect to the need for financing conditions appropriate for restoring projected inflation to its pre-pandemic path, he said. This can vary across time with the macroeconomic outlook, he said.