Fulcrum Research Notes January 2013

Understanding the ECBs monetary policy

Juan Antolin-Diaz juan.antolin-diaz@fulcrumasset.com
Since the financial crisis and the Great Recession of 2008, most major central banks have engaged in non-standard policies of
one form or another. While these policies seem similar across central banks, they can in fact be very different, and comparisons
must be made with care. In this note we analyse why the ECBs policy framework contrasts with the other major Central Banks.
We pay particular attention to balance sheet policies, and we explain why, counter-intuitively, a contraction of the ECBs balance
sheet and an increase in the overnight rate can mean an easing, not a tightening, of financial conditions.

The zero lower bound in interest rates and

having reached the zero lower bound. In 2009, the key

non-standard monetary policies

ECB interest rates reached a record low level, but as

expressed by Trichet (2009):

The first important difference between the ECB and

other central banks, such as the Federal Reserve and

It should be noted that we did not decide today that

the Bank of England, relates to the zero lower bound

the new level of our policy rates was the lowest level

on interest rates. In normal times, the central banks

that

standard instrument to stimulate aggregate demand

circumstances may be. At the same time, with regard

and control inflation would be a short term interest

to the present situation, the Governing Council

rate. Importantly, interest rate policies have a limit:

considers the present level of interest rates to be

when the nominal interest rate reaches zero, it cannot

appropriate,

go lower, since with negative interest rates rational

information and analyses.

agents would always prefer to hold cash rather than

bonds1.

can

never

be

taking

crossed,

into

whatever

account

all

future

available

Indeed, three years later, and on the basis of a

deterioration of the economic outlook derived from the

In the case of the Federal Reserve and the Bank of

Euro Area sovereign bond crisis, the ECB cut rates in

England, as well as the Bank of Japan in the early

November 2011, reversing the increases carried out

2000s, the monetary authorities have been quite

earlier in the year, and again in July 2012, taking the

explicit in admitting that they are constrained by the

deposit rate to a new historical record of zero. Even at

zero lower bound and that, if they could, they would

this point, the ECB does not consider that its key rates

cut interest rates further. For these central banks, non-

have reached their lower bound. Peter Praet, member

standard

of the executive board of the ECB, announced (Praet,

continuation of interest rate policies through other

2012) that the central bank was technically ready for a

means. For example, Bernanke (2012) remarked:

negative deposit rate and that a reduction in the other

measures

can

be

thought

of

as

key ECB rates (narrowing the corridor) was also

To help bolster the recovery and promote price

possible, while admitting that at low levels of interest

stability, the FOMC has provided unprecedented

rates, further cuts would probably have not much

levels of policy accommodation in recent years. With

effect, other than on the exchange rate.

our main policy interest rate near its effective lower

bound, we have been using two complementary tools

The second difference relates to the ECBs view on the

to carry out monetary policybalance sheet actions

use of non-standard measures. While other Central

and forward guidance.

Banks regard non-standard measures as a continuation

of interest rate policies, the ECB adopted the so-called

The ECBs view of the zero lower bound is substantially

separation principle, by which risks to inflation and

different. Firstly, the ECB has never seen itself as

economic activity are addressed with movements in

Understanding the ECBs monetary policy

Figure 1. External financing of

non-financial corporations (%)

interest rates, whereas other measures (such as

balance sheet policies) are used to deal with concerns
about financial stability2.

100

Balance sheet policies (i): Asset purchases

90
80

Non-Bank

70

Confronted with the problem of delivering additional

60

easing at the zero lower bound, the Federal Reserve,

50

the Bank of England and the Bank of Japan all engaged

40

in large scale asset purchases, commonly referred to as

Non-Bank

Banks

30
20

Quantitative Easing (QE). In the case of the Fed, both

10

long term US treasury bonds and mortgage-backed

Banks
Euro Area

securities were purchased, while the BoE and the BoJ

purchased

mainly

government

bonds.

Broadly

United States

Note: Breakdown, in percent, of the sources of external financing of

speaking, the aim of these purchases is, by removing

non-financial corporations, average 2004-2008. Source: ECB

safe assets from the market, forcing investors to

Monthly Bulletin

rebalance their portfolios towards other, riskier, assets,

increasing their prices and depressing yields. It is this
effect on yields, and its impact on the broader
economy, that is the target of Quantitative Easing.
Why has the ECB not undertaken large scale asset
purchases in the style of the Fed? Apart from the fact
that, in principle, the ECB could just lower short term
rates directly, the main reason for not doing QE is the
different structure of financial markets in both regions.
Bank-based financing of households and non-financial
corporations is much greater in the Euro Area, whereas
non-bank lenders and market-based financing and
securitization are more common in the United States
(Figure 1).

The two important exceptions are the Covered Bond

Purchase Programmes (CBPPs) and the Securities
Markets Programme (SMP), now replaced by the
Outright Monetary Transactions (OMTs).
The Covered Bond Purchase Programme (CBPP) was
announced in May 2009 and was targeted at
addressing the loss of liquidity in the covered bond
market, which is the most important privately issued
bond segment in European capital markets, and a
major source of funding for euro area banks. In the
months following the collapse of Lehman Brothers,
this market was showing increased signs of stress, with
widening spreads in the secondary market and reduced
issuance in the primary market, prompting the ECBs

Moreover, while the Fed, the BoE and the BoJ have the

intervention. The CBPP is therefore very similar in

ability to undertake purchases of the one riskless asset

nature and rationale to the Feds QE programmes,

in their economies (i.e. the bonds of their respective

although smaller and more targeted.

governments)

the

existence

of

17

sovereign

governments is an important institutional barrier to

broad-based

operations

in

sovereign

markets.

Therefore, the ECB probably considers that purchases

of government bonds or asset-backed securities would
be ineffective, and prefers to base its demand
stabilisation policies on direct bank lending.

The

Securities

Markets

Programme (SMP)

was

announced in May 2010 with a view to address severe

tensions in European sovereign bond markets after
the eruption of the Greek sovereign debt crisis, which
quickly spread to Ireland and Portugal, and later Italy,
Spain and Cyprus. Concerns about the sustainability of
government finances in these countries had led to
rapid increases in sovereign yields, as well as bank

Fulcrum Research Notes January 2013

Understanding the ECBs monetary policy

credit default spreads. The ECB decided to intervene

behaviour by investors that are hampering the

with the stated purpose of restoring the depth and

transmission of this stance.

liquidity

of

debt

markets

and

ensuring

the

appropriate transmission of monetary policy. In

accordance with the separation principle, the ECB
did not regard the SMP as a measure to further ease
monetary policy, but rather as a way to ensure that the
stance of policy (signalled by the ECB interest rates) is
actually transmitted throughout euro area financial
markets. Indeed, SMP purchases were sterilised in the
sense that the central bank liquidity injected to
undertake these purchases was subsequently reabsorbed by the ECB in weekly operations.

Balance sheet policies (ii): the central bank

as lender of last resort
Walter Bagehot, a 19th century English intellectual, laid
the foundations of the lender of last resort function
with the recommendation that in a financial panic, the
central bank should lend freely at a high rate, on good
collateral to illiquid but solvent banks. The purpose of
these policies is to replace the private interbank
intermediation by central bank intermediation when
the former has become dysfunctional and cannot

The SMP was largely ineffective in reducing sovereign

operate normally. Since the onset of the crisis in 2008,

bond spreads or avoiding contagion to other euro area

the ECB has made extensive use of its lender of last

sovereign markets. The main reasons were its lack of

resort function, and bank lending through the

credibility (due to its ex-ante limited size and the

expansion of the balance sheet has been the

market perception of reluctance to use the programme)

cornerstone of its policies to this day, as is apparent in

and the creation of moral hazard (by reducing the

Figure 2 (see the end of this note for a list of

incentives of the governments involved in the debt

abbreviations). In contrast, while the Fed and other

crisis to improve the sustainability of their fiscal

central banks lent extensively to illiquid banks during

policies). In September 2012, after a renewed

the period of greater financial market tension, these

intensification of financial market tensions, the ECB

facilities have been mostly wound down by now, and as

announced a new programme (Outright Monetary

we have discussed, their balance sheet policies now

Transactions, or OMT) designed to substitute the SMP

target overall monetary conditions.

and address the latters deficiencies. Although the

OMT has not been activated as of the writing of this
note, the mere threat of unlimited bond purchases
seems to have been more effective than its predecessor
programme in improving financial conditions.

The most important policy tool used by the ECB is the

introduction in October 2008 of the fixed rate full
allotment procedure for its weekly Main Refinancing
Operation (MRO). Under this procedure, stressed (but
solvent) banks that can provide adequate collateral

To conclude this section, although sometimes they

have unlimited access to ECB liquidity at a fixed rate.

have been made comparable in the financial press, the

For example, a Spanish or Italian bank that, because of

ECBs government bond purchasing programmes

concerns related to the fragmentation of the Euro Area

remain very different from the other Central Banks.

in the first half of 2012 saw itself cut out of the

The stated objective of the ECBs programmes is not to

interbank lending, could, under eligible collateral and

target overall monetary conditions, but disruptions in

after paying the MRO rate, obtain an unlimited

certain markets subject to malfunction or irrational

amount of liquidity to meet its obligations, thus

avoiding a disorderly default.

Fulcrum Research Notes January 2013

Understanding the ECBs monetary policy

Figure 2. The ECB's balance sheet: liquidity provision and absorption

1750
1250
750
250
-250
-750
-1250
2007

2008

2009

Covered Bond Programme

LTROS ex 3year
Current Accounts

2010

2011

2012

SMP
MROS
Deposit Facility net of MLF

2013

3-y LTROS
Liquidity Absorbing FTOs
Aut. Factors and Reserve Requirements

Note: See the end of this document for definitions. Source: ECB.

The fixed rate full allotment procedure has two

lending rates to households and corporations in the

important implications: first, the ECBs balance sheet

periphery of Europe.

becomes demand-determined, i.e. the size of the

balance sheet is not a policy decision, but a reflection
of euro area banks liquidity needs. Second, as a
consequence of this, the ECBs balance sheet expands
and contracts flexibly depending on the functioning of
the interbank market. Risk aversion or abnormal
liquidity preference by euro area banks will lead to an
expansion of the balance sheet. An increase in
fragmentation, by which banks in core countries refuse
to lend to banks in other countries because of
perceived counterparty risk, will lead to increased
central bank intermediation and also expand the
balance sheet.

The ECB has complemented the use of its Main

Refinancing Operation with 3, 6, 12 and 36-month
Longer Term Refinancing Operations (LTROs). The
rationale is similar to the regular operations, but their
aim is to address liquidity shortages at greater
maturities. The 3-year LTROs announced in December
2011

were

remarkably

large,

and

essentially

quadrupled the amount of excess liquidity deposited at

the ECB within the space of a few months. They are
also conducted under the fixed rate full allotment
procedure, meaning that the ECB acts as a rate giver,
and the private banks determine the volume of
borrowing. The 3-year LTROs have sometimes been

Therefore, while a contraction in the Feds balance

compared

sheet signals a tightening of the stance of monetary

programmes, especially since there is evidence that

policy, not only is this not true with regards to a

many banks used the ECB liquidity to purchase

contraction

but

government bonds of distressed countries, driving

furthermore the latter is evidence of an improvement

down their yields at least temporarily. Apart from the

in financial conditions and a reduction in interbank

immediate

market

have

emphasised, it is important to keep in mind that under

important consequences for the transmission of lower

QE, the Fed controls the amount of government bond

of

the

segmentation.

ECBs

This

balance

will

sheet,

probably

to

the

differences

Feds

which

Quantitative

we

have

Easing

already

purchases, and becomes the owner of these bonds,

Fulcrum Research Notes January 2013

Understanding the ECBs monetary policy

Figure 3. Key ECB interest rates and the overnight rate

6

Marginal Lending Facility

Rate
4

Main Refinancing
Operation Rate

Deposit Rate
1
EONIA
0
2007

2008

2009

2010

2011

2012

2013

Note: see the end of this document for definitions. Source: ECB.

while with under LTROs, it is in principle a private

interbank market ensures that the overnight interest

business decision by banks to purchase government

rate is equal to (or marginally above) the opportunity

bonds, and banks are free to keep them or sell them as

cost of reserves, which is precisely the deposit rate. A

they see fit once they give back the ECB liquidity.

similar situation, albeit with a different origin, can

An interesting consequence of the large amount of

excess liquidity currently in place in the Eurosystem is
the fact that the overnight rate (EONIA) is currently
compressed against the floor of the ECBs interest rate
corridor, determined by the Deposit Rate. In normal
times, banks manage their regular liquidity needs by

currently be observed in the US. The Fed has been

financing its large scale asset purchases with newly
created reserves, that is, by the injection of large
amounts of central bank liquidity. As a consequence,
the fed funds rate has been trading very close to the
interest rate paid on reserves.

borrowing at a penalty rate from the Marginal Lending

The situation in the euro area is more complicated

Facility and depositing any excess liquidity at the

than in the United States because of the fragmentation

Deposit Facility, earning the deposit rate. Under

of the European interbank market as a consequence of

normal circumstances, banks will efficiently manage

the sovereign debt crisis. In short, while creditworthy

their liquidity needs so that excess liquidity is zero on

banks from core countries are able to access the

average, and the overnight rate will be very close to the

interbank

mid-point of the corridor, which corresponds to the

unsecured overnight funds at the EONIA rate, banks of

minimum bid rate of the Main Refinancing Operation.

peripheral countries have been totally or partially cut

In a situation of financial stress, when the supply of

central bank liquidity (known in the US system as
reserves) becomes perfectly elastic, and central bank
liquidity is ample, as happened with the ECBs fixed
rate full allotment policy procedure, arbitrage in the
Fulcrum Research Notes January 2013

market,

and

are

therefore

obtaining

off from the unsecured interbank market, and can only

finance themselves through the ECBs operations, at a
rate of 0.75%. The current spread between the EONIA
rate and the MRO rate, and the presence of excess
liquidity in the system are therefore both a sign of
financial fragmentation. If peripheral banks regained
5

Understanding the ECBs monetary policy

access to the interbank market, they would reduce the

Of course, given that the EONIA rate is pegged to the

amount of central bank lending they require, shrink

Deposit rate, the ECB could reduce the spread between

the ECBs balance sheet, and drive up the EONIA

EONIA and the MRO rate by narrowing the interest

towards the MRO rate. Thus, somewhat counter-

rate corridor, i.e. by reducing the MRO rate and the

intuitively, an increase in the overnight rate would still

MLF rate while keeping the deposit rate at its current

not constitute a form of monetary policy tightening,

level. While this policy would represent a lowering of

but an improvement in financial conditions and a

effective interest rates for banks in peripheral

reduction of fragmentation3. Presumably the spreads

countries while keeping constant rates for banks in

over interbank rates currently being charged by

core countries, the ECB has expressed its preference

peripheral banks to households and non-financial

for a wide corridor in order to ensure smooth market

corporations would also be reduced.

functioning (see for example Praet, 2012)

When will the spread between the EONIA and the

Other policies: collateral management and

MRO be reduced? The announcement of the OMTs and

communication

the recapitalisation of the Spanish banking system

have certainly helped to reduce the perception of risk

The final two ECB policies that we will consider here

of peripheral banks, but a large amount of excess

are the collateral framework and their use of

liquidity is still present in the system. Although it is

communication to affect expectations.

difficult to pin-down a precise number, the experience

of the years 2009 and 2010, when excess liquidity
decreased substantially and the spread was reduced,
seems to indicate that this spread will remain at
around 60 basis points as long as excess liquidity is at
least 100-150 billion Euros.

managing the collateral framework (modifying the

eligibility and haircut rules) that determines which
assets euro area banks can post as collateral to obtain
funding from the ECBs lending operations. Most
importantly, the combination of acceptance of credit

Figure 4. Relationship between the EONIA

spread and ECB liquidity surplus, 2009-2010.

claims to non financial corporations as eligible

collateral and the extended maturity of the Long Term
Refinancing Operations has resulted in what the ECB
regards as a very similar programme to the Bank of

10

Englands Funding for Lending Scheme, at the same

0
EONIA-MRO spread, bps

With regards to the first, the ECB has been flexibly

time providing liquidity to the banking system and

-10

incentivising banks to lend to non-financial businesses.

-20
-30

Another important difference between the ECB and

-40

other major central banks, especially the Federal

-50

Reserve, relates to their communication policy. In

-60

particular, the Feds policy of forward guidance, by

-70

which

-80
0

100

200

300

Excess Liquidity, EUR billion

400

they

announce

their

intention

(perhaps

commitment) of keeping short term interest rates low

for an extended period of time, and most recently at
least until the unemployment rate has gone below a

Source: ECB.

certain threshold, contrasts with the ECBs motto we

never pre-commit. While it seems that the Fed has

Fulcrum Research Notes January 2013

Understanding the ECBs monetary policy

been relatively successful in its attempts to use
promises about the future path of interest rates to
affect current monetary conditions, the ECB maintains
the view (shared by other central banks, such as the

List of Abbreviations
ECB standing facilities

Bank of England) that Central Bank commitments face

MLF: Marginal lending facility

a problem of time inconsistency (by which a

MRO: Main refinancing operation

policymaker makes a promise which, if believed, it will

DF: Deposit Facility

have a strong incentive to break in the future, and is

therefore not believed in the first place) and is

Note: The interest rates associated with these facilities

therefore better to commit to objectives (such as 2%

are known as the key ECB interest rates and provide,

inflation) than to instruments (such as a given path for

respectively, a ceiling, average and floor for the

interest rates).

overnight interbank rates. The difference between the

Marginal Lending Rate and the Deposit Rate is known as

Conclusion
This note has explored the differences between the
monetary policy framework of the ECB and other
major Central Banks. Although some policies such as
the expansion of the balance sheet might appear
similar, they have very different purposes and
implementations, while others, such as LTROs and
Funding for Lending Schemes might be more similar
than they appear at first sight. These differences arise

the interest rate corridor.

ECB non-standard measures

CBPP: Covered Bond Purchase Programmes

SMP: Securities Markets Programme

OMT: Outright Monetary Transactions

LTRO: Longer-Term Refinancing Operations

Other

because of the distinct characteristics of financial

EONIA: Euro OverNight Index Average

markets in different areas, the different institutional

FTO: fine tuning-operations

frameworks and the different objectives and policy

problems of the various central banks.

Note: Liquidity absorbing FTOs are used to sterilise

the liquidity injected by ECB open market operations.

Notes
1. It is theoretically possible for the interest rate on
bonds to be slightly below zero if the costs of physical
storage of cash are positive, but the practical
implications of negative rates on the functioning of
money markets are not well understood.
2. For a detailed explanation by the ECB of their
monetary policy framework since the crisis, see Eser et
al. (2012).
3. In principle this could be regarded as a tightening of
overnight rates for core countries and an easing for
peripheral countries, which the same thing as a
reduction in fragmentation.
Fulcrum Research Notes January 2013

References
Bernanke (2012), Transcript of Chairman Bernankes
Press

Conference,

Federal

Reserve

Board

of

Governors, September 13, 2012.

Eser, Carmona Amaro, Iacobelli, and Rubens (2012)
The use of the Eurosystems monetary policy
instruments and operational framework since 2009,
ECB Occasional Paper Series, n. 1355, August 2012.
Praet, P. (2012), Transcript of Q&A with ECBs Praet,
The Wall Street Journal. Retrieved 22/01/2013.
Trichet (2009), Introductory Statement with Q&A,
ECB Press conference, 7 May 2009.
7

Understanding the ECBs monetary policy

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Fulcrum Research Notes January 2013