ECB Insight: Insider Thinking on the Operational Framework

15 February 2024

By David Barwick – FRANKFURT (Econostream) – In a departure from our usual formats, we simply reproduce here, unvarnished, some insider thinking on various aspects of the operating framework of the ECB, a subject currently under review by the Governing Council.

On where things stand: We are in the intermediate stage, having discussed the issues several times already within the Council. I expect we’ll get to the advanced stage in the spring. There is no fixed date for the ultimate decision, it depends also on everyone’s reactions and comments. We are not in a hurry, and we will not conclude the review before we reach, at a minimum, a high degree of consensus. It’s rather unlikely that one more round of discussion would be enough to get us to that point, but we can discuss whatever we want whenever we are all together, even if we then have to save the decisions for the monetary policy meeting. Also, it’s worth remembering that we will probably be facing a very different set of circumstances by the time most of our portfolio matures. Therefore, I would reject the idea that there is some ultimate point after which the operating framework is written in stone and cannot be further adapted to whatever the appropriate sort of monetary policy implementation is. For good reason, everyone expects anyway that for some time, a supply-driven floor will continue to apply.
On high excess liquidity: This is not a bad environment for us to approach the issue of the operating framework, because it’s preferable to deal with these questions when there is no pressing need, which is the case when the level of liquidity is as high as it is now. We can take our time and examine all the relevant aspects. At some level of excess liquidity, this will no longer be the case, but that level is probably in the hundreds of billions of euros, and we will reach a conclusion well before we get there. Nobody can really say with certainty at what point the excess liquidity would be so low that it would start impacting the short-term market rates.
On the future balance sheet size: Given all the instruments and options available to us thanks to our general documentation, and taking into account a quarter of a century of practical application of these tools, there isn’t much question that we have a sufficiently flexible framework with enough choices when it comes to formulating the operational framework that we can implement and steer rates with high precision, independent of what the balance sheet size is. So, if there is a monetary policy-based argument for a specific kind of balance sheet, then from an operational perspective that needs to be taken as a given, and the operational framework has to adapt to that. In other words, monetary policy dictates operational aspects, and monetary policy includes the size of the balance sheet. Looking at QE, just as an example, it’s clear that the size of the balance sheet was driven by our monetary policy stance. All that said, I would suggest that the key issue may not be the size of the balance sheet per se, but how we compose it, for example, whether liquidity needs are satisfied via outright purchases or credit operations. If the answer is outright purchases, then the question becomes whether we are going to make so many purchases that it is the deposit rate that determines the starting point for the yield curve. If there is a monetary policy-based reason for purchases, then for sure we need to do them, and in this case we can say that we need to have a supply-driven approach to set the rates by the deposit facility rate. Now, once we don't have the policy argumentation for huge purchases, it's more difficult… So, if there is not - for example, for ELB or zero lower bound reasons - a need for us to maintain an accommodative monetary policy stance by making purchases, it’s hard to justify why the central bank should be doing large purchases. But it doesn't need to mean that a strong central bank is not doing outright purchases, because there will be - and even before the global financial crisis there already was - a need for our balance sheet to include more than just credit operations. Because just the demand for banknotes in the euro area is large enough to have quite a big need for liquidity or bank reserves. And that's why we needed to be creating liquidity. And to that extent, I don't see that there is any reason to do it only via credit operations.
On whether meaningfully shrinking the balance sheet further can only be via active sales: If you want to do it quickly, yes. In 5 to 10 years, as things now stand, presumably the balance sheet will be much smaller. But if you want the balance sheet to shrink in a big way within the next three years, then you have to do outright sales.
On whether, when the ECB communicates a decision on the operating framework, it should be taken to imply anything about when or if active sales will occur: If we were to come out and announce, ‘We want an operating framework consistent with a balance sheet size of x’, and we're at x plus y right now, then indeed, that could potentially carry such an implication. Or it could be that we want to go back to the original framework with the true corridor, where the interest rates are steered by the midpoint of the corridor, and we want to do it quickly. That would also imply sales. But it could be that we need such a large balance sheet that we never need to do any sales or don't even need to let all the portfolios mature. In the end, I suspect that there will be a long lead time in any case. And as mentioned, it’s the operational framework should be adjusting to the monetary policy needs. From this point of view, why should we start rapidly shrinking the balance sheet for operational framework purposes if we don't have a monetary policy reason for that? But if there is a monetary policy reason for selling, then the operational framework should adapt to that.
On what other decisions are tied to the decision on the operational framework: The rates corridor is clearly part of the operational framework. And I would say that our minimum reserve system also is. With the exception of the remuneration, which is a monetary policy instrument. Okay, in some instances the question of the remuneration could be operational. For example, if circumstances warrant a higher liquidity deficit of the banking system, then you could increase it for operational reasons.
On whether the ECB would adjust the corridor before the decision on the operating framework: It’s hard to see what possible motivation there could be for that, because the corridor is not effective. It’s the DFR that impacts everything in the markets.
On whether the decision to change the corridor will come as soon as the decision on the operating framework is made, or will have to wait until there's less excess liquidity: If we see a need to adjust the corridor from the operational framework perspective, it can be done at any moment. I don't see a link to the excess liquidity, because as long as we have this huge excess liquidity, it is the DFR that is relevant. But certainly, for day-to-day rate volatility or financial stability, or whatever other reasons there might be for changing the width of the corridor, that's not strongly tied to the amount of the excess liquidity. And as to the width of the corridor, certainly we need to have a view on that in the operational framework review, but it still needs to be a parameter that can be changed at any moment if there is any need. As we've seen, when the markets are hit by a crisis, we need to do that.
On how the ECB gets to where it wants to go, given it is not starting from zero, but rather a supply-driven floor system in effect: Unless we want exactly what we have now, which I don’t expect to be the case, then we have to transition to where we want to be, which could be done in stages. For example, if over the long run we wanted to get back to something like our original corridor system, and if we didn't want to do huge outright sales, then probably when we are near to the neutral liquidity but not in a clear liquidity deficit when the banks need to start borrowing heavily from operations, a narrow corridor would reduce the unnecessary volatility of short-term rates.
On whether the US Federal Reserve’s adoption of a floor system on a permanent basis affects the ECB’s decision: The Fed is an important player in global financial markets of course, and its decisions impact us, but with that I am referring to their monetary policy stance. The operational framework, not so much. There are structural reasons for the ways we’re different. They have a limited number of counterparties, whereas we have thousands. Their financial markets are more capital market-based, while ours are based more on bank lending. So, there are very valid reasons for having different kinds of operational framework. That doesn’t mean we’re not pursuing similar outcomes: we both want stable short-term rates.
On whether steering short-term rates will be the ECB’s objective under a new operating framework: I don't see why we should abandon the guiding principle of setting monetary policy by steering the short-term end of the yield curve, meaning very short-term or overnight. Whatever the new framework will be, the core principle is likely to be that we need to be able to steer the short-term end of the yield curve.