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2019-09-20Macro `n Cheese

Did Mario step into fiscal space at his last monetary policy meeting?

This week, Roger has written an account of the ECB's latest monetary policy decision and how it reflects increasing political tensions within Europe.

Mario is missing!

Last week, Mario Draghi fought his last CPI boss fight and we think it is safe to say that some of the Bowsers in the ECB's governing council felt quite overrun by Super Mario. For all Europhiles, most economists, and a fair share of the continent’s politicians, Draghi will probably be remembered as one of the most prominent central bank presidents ever; pivotal in defending the integrity of the Euro Area and, with it, the European Union at the depths of the European crisis in 2012.

From another perspective, and honing the evaluation to the ECB's price stability objective, Mario Draghi is by far the worst performing ECB-president in the ECB's, admittedly short, history.

*I hope all readers appreciate the arduous work of matching the colors of each ECB-president to that of the jerseys of the respective national football team.

Of course, previous ECB-presidents did not face the challenges Draghi has, and Trichet, in particular, has been widely criticized for not acting more forcefully during the global financial crisis, as well as the premature hikes in 2011. Draghi, to the contrary, will go into the history books as the ECB-president who never hiked rates and who was (all too?) willing to seek out new ways of supporting the European economy.

True to form, in his (penultimate) monetary policy meeting, Draghi produced a bonfire of new and semi-new stimuli measures. That said, and especially given the unusual amount of dissenting voices in the governing council (GC), it is understandable that many market pundits are expressing some doubts about ECB:s commitment to Draghi’s promises.

However, by making all announced measures contingent on key ECB interest rates to remain at their present or lower levels until “ […]the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within its projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics”, Draghi effectively tied the hands of his successor and the whole governing council. At the very least, this pushes any notion of GC and Lagarde backtracking not just a few months but, more probably, years into the future.

Intriguingly, when taken together, the measures announced also open up for quite strong fiscal policy responses; far beyond what Draghi’s forlorn comments on how “governments with fiscal space should act” suggested.

In short, the GC agreed on three broad swathes of policy changes:

  1. A reduction of the deposit rate (by 10bp to -0.5%) combined with a much-expected tiering system. Up to six times the volume of required reserves (currently standing at EUR bn 133), i.e. around 800 billion EUR, can be exempted from the negative deposit rate and will instead carry a rate of 0%. Interestingly, the ECB states that both the rate (0%) and the multiplier (RR*6) “can be changed over time”, meaning they effectively become new policy tools and not mechanically linked to any other policy instruments.
  2. Restarting (as of 1 November) and tweaking the Asset Purchase Program (APP), where volumes have been held constant since the end of 2018 in a “reinvestment phase”. The pace of net purchases will amount to 20 billion EUR, and, due to a generally lower interest rate environment, the GC decided to extend the option of buying assets yielding below the deposit rate (-0.5%) to also include the private sector instruments (covered and other asset-backed bonds, as well as corporate bonds).
  3. Modifying the terms of the previously announced third round of Targeted Long Term Repurchase Operations (TLTRO III), to, among other things, extend maturity from two to three years and aband the planned use of a 10bp premium to the to the average MRO for the duration of each TLTRO (III) operation.

Normally, I think the immediate market developments surrounding a policy decision is a good starting point for discussing the effects of monetary policy decisions. This time, alas, markets provided very little to go by: At first, markets seemed disappointed as the depo-rate cut (and the size of monthly APP-purchases) was somewhat smaller than expected. Then, as the news of an open-ended QE and the tightened forward guidance sank in, rates came back down and the EUR weakened again, but only to come back up again when Draghi brushed off any talk on side-effects (not explicitly addressing the problem with ISIN/issuer-limits), and the amount of dissonance within the GC became clearer.

To be fair, it was a lot of news to take in, and some of the effects were not even clear until this Thursday (19 Sept), when the first TLTRO III operation was performed.

As always with “Graf Draghila”, the devil is in the detail

With the luxury of having a week of afterthought between us and the decision, the most talked about feature has been the lowering of the depo-rate and the restarting of the APP, together with the amount of resistance this has met both within and outside the ECB. And, for once, I think the Draghi-critics are right, but more in form than substance. I, too, propose a more political, even fiscal, interpretation of Mario’s farewell package.


Starting off by discussing the tiering system, we can see that, thanks to the generous calculation of tiers (6*MRR), the banking system cuts its costs for depositing money with the ECB by more than half! Put another way, this means that the weighted deposit interest rate increases by some 20bp despite the deposit rate being lowered from -0.4% to -0.5%.

Simultaneously, with the modification of the TLTRO, the ECB also cut eligible banks’ effective lending rate.

However, considering that Minimum Reserve Requirements are calculated individually for each bank and then aggregated, the impact of tiering is of course very different from bank to bank and from country to country. – Here, I would of course love to write that you are able to precisely calculate the exempted volumes with data already available in the application. But, unfortunately, we have only found detailed minimum reserve data from Germany[1].

[1] If you happen to know of other Euro Area countries that publish Minimum Reserve data, you know where to contact us!


Thankfully, a number of commentators have already made considerable efforts in calculating the MRR on a country-by-country basis (e.g., here, here and here), but for the purpose of this article, it actually suffices to conclude that it is mainly the usual suspects (Yes, looking at you, core Europe[1]) who are holding large excess reserves (>6*MRR), while most (not all!) peripheral countries are holding much lower excess reserves.

In all, this should imply that (banks in) peripheral countries are able to take advantage of a low ECB lending rate and place that in excess reserves (transferred from core countries) and pocket the difference[2]. At the limit, a bank could be able to get as much as a 0.5% from borrowing TLTRO (at a negative 0.5%) and paying 0% for excess reserves below the 6*MRR limit! Nice!

[1] With core Europe, I of course mean Germany, France, Netherlands etc., whereas peripheral Europe is Italy, Spain, Portugal etc.

[2] And, despite the very weak uptake from yesterday’s TLTRO III, I take it this will materialize in coming rounds when peripheral banks are given more time to prepare.


Now, let’s extrapolate a bit on what we just discussed (but infamously – ceteris paribus – refraining from addressing other aspects of the ECB’s decision).

The “tiered reserve rate” (TRR) as well as the multiplier are obviously independent of other monetary policy tools (such as the TLTRO rate). Already, but especially if we move these policy levers further, (i.e., higher TRR, higher multiplier and a lower TLTRO-rate), the ECB will effectively transfer profit from national central banks in the Euro system to… – drum roll – …private banks!

When I first read and understood this, I was certain that Draghi and the GC had committed a major policy mistake. Yet, thinking the details through, I realize that Draghi has probably outsmarted me (again):

  1. The benevolent, but somewhat stale, interpretation is that by raising profit at private banks, these might be persuaded to lend more freely to households and corporates again. (As if!)
  2. However, and much more importantly in my opinion, if demand and inflation continue to disappoint, the explicit transfer of (seigniorage) incomes from (core) national central banks to (private) peripheral banks is sure to provoke a (core) fiscal response somewhere down the line.
  3. This pressure on fiscal policy to act will be exacerbated by an open-ended QE, set to drive excess reserves and Target 2 balances relentlessly higher, increasing the implicit (and hard-to-control) transfers within the monetary union.
  4. By sharpening the forward guidance and making all policy measures contingent on it, the GC and – by extension – future ECB president Lagarde, have no choice but to fully commit to Draghi’s farewell message.

Thus, in his final appearance, Draghi succeeded to push the ECB’s monetary policy as close to fiscal policy as it can possibly get. Being Super-Mario, he might even have managed to push fiscal policy into action. One thing is clear: European economic policy will never be the same...