By Christophe Blot and Paul Hubert

In December 2016, the European Central Bank announced the continuation of its Quantitative Easing (QE) policy until December 2017. The continuing economic recovery in the euro zone and the renewal of inflation are now raising questions about the risks associated with this programme. On the one hand, isn’t the pursuit of a highly expansionary monetary policy a source of financial instability? Conversely, a premature end to unconventional measures could undermine growth as well as the ECB’s capacity to achieve its objectives. Here, we study the dilemma facing the ECB [in French] based on an analysis of credit cycles and banking activity in the euro zone.

The ECB’s announcement gives us two signals about the direction of monetary policy. On the one hand, by delaying the end date of QE, the ECB is implicitly announcing that the normalization of monetary policy, in particular a hike in its key rate, will not take place before early 2018. The ECB will thus continue its expansionary policy of increasing the size of its balance sheet. On the other hand, the reduction in monthly purchases is also a sign that it is toning down its expansionary character. The announcement is similar to the “tapering” that began in January 2014 by the US Federal Reserve. Purchases of securities were cut back gradually, until they actually stopped at the end of October 2016.

The undeniably expansionary nature of monetary policy in the euro zone suggests that the ECB still considers it necessary to implement a stimulus in order to achieve its ultimate monetary policy objectives. The first of these is price stability, which is defined as inflation that is lower than but close to 2% per year. There are no signs of either runaway inflation or growth [1] [2]. The securities buyback programme should help to consolidate growth and push inflation towards the 2% target. At the same time, the liquidity issued by the central bank in its securities purchase programmes and the low level of interest rates (short and long term) are fuelling fears that monetary stability might have an adverse effect on financial stability[3].

The result leaves the ECB facing a dilemma. Putting a premature end to quantitative easing could keep the euro zone in a state of low inflation and low growth. Unnecessarily prolonging QE, while the US Federal Reserve has begun normalizing its monetary policy, could create a risk of financial instability, resulting in an uncontrolled surge in asset prices, credit, and more broadly the risk taken on by the financial system.

We assess this dual risk using indicators on the activity of the banking system of the euro zone as a whole and of the countries that make it up. Credit, whether granted to households or to non-financial enterprises, is central to bank assets and often at the heart of risks to financial instability[4]. Here we propose extending the analysis to the size of the balance sheet and to total loans granted – including credit to other monetary and financial institutions – which makes it possible to measure the risk associated with the banking system as a whole[5].

These different variables are related either to GDP, which makes it possible to capture the disconnection between banking activity and real activity, or to the capital and reserves of the banking system, which makes it possible to capture the leverage effect, i.e. the capacity of the system to absorb losses. Here we focus on quantities rather than prices, using indicators such as the ratio of credit granted on equity and the ratio of credit received on income. These are central to reflecting the transmission of monetary policy and to assessing the risk of financial instability.

The graph shows the changes in the credit cycle, relative to GDP (blue line) and relative to the capital and reserves of the banking system (red line) [6]. The green areas indicate periods when credit deviates significantly above or below its long-term trend. In general, the analysis of credit and of the size of the banking system’s balance sheet points to a recovery in activity but it does not suggest either a credit boom or an excessive contraction in the euro zone in the recent period. While credit is evolving in a relatively more favorable direction relative to its trend in France and Germany, the cycle does not indicate an excessive increase. The Netherlands and Spain are distinguished by a low level of credit relative to GDP. For the Netherlands, this trend is confirmed by the indicators relative to the banking system’s capital and reserves, while in Spain, outstanding loans relative to capital and reserves are at a historically high level, suggesting an excessive level of risk-taking given the economic situation.

[1] Translation errorDespite the recent rebound in inflation, which is largely linked to the rise in oil prices and inflation expectations, inflationary pressures are still moderate, and getting inflation back to the 2% target is not sufficiently sure to warrant a change in the direction of monetary policy.

[2] Unemployment is still high, fuelling deflation.

[3] A recent analysis by Borio and Zabai (2016) of the effectiveness of unconventional monetary policy suggests that its effectiveness could decrease even as the risks involved increase. The role of asset prices has been studied by Andrade et al. (2016), showing that asset prices had reacted, as expected, following the measures taken by the ECB, and by Blot et al. (2017) on an assessment of the risk of bubbles.

[4] See Jorda et al., 2013 and 2015.

[5] Translation errorThe Basel III legislation is based on risk indicators calculated at the level of banking establishments, while our approach is based on macroeconomic indicators.

[6] Translation errorThese cycles are obtained using a principal component analysis (PCA) of several types of trend / cycle breakdowns: the Hodrick-Prescott filter, the Christiano-Fitzgerald filter, and the moving average.

Christophe Blot and Fabien Labondance

As expected, on 5 June 2014 the European Central Bank (ECB) unleashed an arsenal of new unconventional measures. The aim is to curb deflationary tendencies in the euro zone. Among the measures announced, the ECB decided in particular to apply a negative interest rate to deposit facilities. This unprecedented step deserves an explanation.

Note that since July 2012, the rate on deposit facilities has been 0%. It now falls to -0.10%, meaning that a bank depositing cash at the ECB will have its deposit reduced by that rate. Before considering the repercussions of this measure, it is worth clarifying the role of deposit facilities. The ECB’s activity is baed on loans to credit institutions in the euro zone through the channel of main refinancing operations (MRO) or long-term refinancing operations (LTRO). Prior to the crisis, these operations were conducted at variable rates based on an auction mechanism, but since October 2008 they have been conducted at fixed rates. The refinancing operation rates must allow the ECB to influence the rate charged by credit institutions for interbank loans (Euro OverNight Index Average rates, or Eonia) and, through this channel, the entire range of bank rates and market rates. To ensure the Eonia is not too volatile, the ECB provides the banks with two facilities: credit facilities, enabling them to borrow from the ECB for a period of 24 hours, and deposit facilities, enabling them to make cash deposits with the ECB for a period of 24 hours. In case of a liquidity crisis, the banks thus have a guarantee of being able to lend or borrow via the ECB, at a higher for credit facilities or a lower rate for deposit facilities. These rates can then be used to regulate fluctuations in the Eonia, as shown in Figure 1.

In practice, until the collapse of Lehman Brothers in September 2008, banks made little use of deposit facilities, indicating that the interbank market was functioning normally. The situation has radically changed since then, and the amount of deposits left with the ECB has fluctuated to a greater or lesser extent, depending on concerns over the sovereign bond crisis (Figure 2). The height of the crisis in spring 2012 coincided with a peak in the amounts deposited by the banks, which had excess liquidity. Over a period of three months, around 800 billion euros (equivalent to just under 10% of euro zone GDP), paid at 0.25%, were deposited by Europe’s banks. In the context of fear of a euro zone collapse and uncertainty about the financial situation of financial and non-financial agents, the banks have been depositing poorly compensated sums with the ECB. They chose to do this rather than to exchange the excess liquidity in the money market or support activity by lending to companies or buying shares. It was not until Mario Draghi’s statement in July 2012 that the ECB would do “whatever it takes” to support the euro zone that confidence returned and these sums fell. It was also then that the rate went down to 0%, further reducing the incentive to use the deposit facilities. The level of deposits fell by half, from 795.2 billion euros to 386.8 billion. Since then, they have declined gradually, but are still high, especially given that they receive no interest. In the last week of May 2014, there were still 40 billion euros in deposits (Figure 2).

This situation prompted the ECB to set a negative rate in order to encourage commercial banks to reallocate this money. We can be sure that once the negative rate applies, the level of deposits will quickly drop to zero. Even so, this will mean an impulse of only 40 billion euros, and further action will be needed to support the real economy. On its own, this step by the ECB has certainly not convinced the markets that it has dealt with the situation.

The ECB has thus once again demonstrated its proactive approach to curbing the risks facing the euro area. Its reaction can be compared to the response of Europe’s other institutions, which have struggled to fully take on board the depth of the crisis. Looking outside the euro zone, it is noteworthy that the US Federal Reserve and the Bank of England moved with greater speed, even though the risk of deflation was lower in the United States and the United Kingdom. This active approach is perhaps no stranger to the renewed growth seen in these countries. The ECB’s action is therefore welcome. Now we need to hope that it will stave off the risk of deflation hanging over the euro zone, a risk that could have been avoided if the euro zone’s governments had not generally adopted austerity policies, and if the ECB had taken less of a wait-and-see attitude.