How It Works: ECB Balance Sheet Reflects Challenges of Monetary Policy

Welcome to our new section How It Works! It will be devoted to exploring both financial and economic concepts, usual and having huge impact on our everyday economic behaviour, business relations and financial system, but unusual to talk about and discuss at the level of intermediate economics since they don’t fall under any of the core topics of the discipline. In this article, we will try to analyse the recent changes in operations of the central bank of our monetary system and relate them to issues on the macroeconomic scale.

In the last decade, central banks have become well-known players in world economy, helping it to return to the previous growth levels. Starting with the financial crisis in 2007-08, central banks tried beyond their usual operating frameworks. The reflections of monetary policy programmes introduced by the ECB can be found in its balance sheet.

The main items on the asset side are monetary policy tools and investment portfolios. Bearing in mind that the main point of the ECB monetary policy is to maintain price stability and inflation below but close to 2%, let us have a look on what measures have been taken through altering the size and composition of the ECB balance sheet.

The recent changes in assets were affected by monetary policy tools. The balance sheet expanded vastly by about €1000 billion hitting €3100 billion in result of two three-year longer-term refinancing operations conducted in December 2011 and February 2012, carried out to provide banks with additional financing. The idea behind it was the same as in case of introduction of negative deposit facility rates later – to boost the economy by making banks taking more money in order to buy assets or use for lending to businesses and consumers; these actions were supposed to bring back the growth of the economy. However, since that time the inflation rate in the Eurozone was not even close to 2%.

Later on, starting from 2013 until September 2014, the size of BS declined with repayments of those LTROs. It was September 2014 when another cycle of widening of the balance sheet took place, with targeted Longer-Term Refinancing Operations (TLTROs) program announced on 5 June 2014. Again, its main purpose was to support Eurozone credit institutions’ lendings to real economy. In March 2015 the ECB, following other central banks and Mr Draghi being inspired by Japan’s experience of lifting the inflation, launched the quantitative easing programme, the essential idea of which is creating money in order to buy government bonds, again in order to boost the economy. The way it is supposed to stimulate the economy is encouraging banks to issue more loans due to higher opportunity costs. Generally, the QE programme is considered to be used when other monetary policy tools are not effective anymore. The current QE programme provides €60 billion euro monthly for such purposes. The QE includes third Covered Bond Purchase Programme (CBPP3), Asset-Backed Securities Purchase Programme (ABSPP), and Public Sector Purchase Programme (PSPP). The last one may be the most crucial, because it is where the private sector benefits the most.

The ECB creates electronic money in order to buy out bonds and place them as central banks’ assets. Consequently, the demand for those bonds grow, and the prices go up. Inversely, bond yields decrease and push down the risk-free rate in the economy. Companies and banks face lower interest rates, which positively affects their cash flow, especially those with low return spreads already. In this way, the digitally created money eventually accumulates in the private sector, stimulating companies to invest more and banks give out more loans. Having obtained loans, consumers spend or invest more money, therefore prices rise. Finally, price appreciation means inflation, and that is exactly what the ECB is aiming for in the current situation. Moderate inflation leads to higher economic growth through increased capital expenditure, which is the main purpose of the QE programme conducted by the ECB.

As to liabilities side, monetary policy tool there include current accounts, the deposit facility and other liquidity absorbing tools. Crucially, reflecting the changes of assets, it was the deposit facility that increased after previous mentioned two three-year LTROs. This is exactly the evidence of LTROs’ malfunction: banks preferred to deposit some money back to the ECB instead of making contribution to the real economy by providing loans from excess funds. Some statistics gives us a better understanding: euro broad money (M2) supply is 10.2 trillion, and banks are required to hold minimum reserves at 113 billion altogether. The current standing facility is in turn 465 billion. In other words, the ECB obliges to hold 1 in each 100 € standing as reserves, but there are excess 3.5 €, which are the unused potential of the real economy. Moreover, this is despite the fact that zero deposit facility rate was introduced in July 2012, to make holding these reserves unprofitable for banks, when standing facility dropped just temporarily. The situation is the same today, ironically challenging the -0.3% annual “penalty” for holding reserves in face of negative deposit facility rate.

The only event later that affected the liability side to decrease was the halt of Securities Market Programme (SMP) sterilisation, which was the process of keeping the money supply stable by offsetting asset purchases.

The programme of QE is prolonged until at least March 2017 or any longer until some significant adjustments to the desirable 2% happen. Probably March 2017 looks too optimistic for the goals set. The reason for doubts is the forecast for inflation by the ECB which by the last data was estimated to be 0.7% in 2016 and 1.4% in 2017, which, in turn, may be lowered in the next projections for inflation in March 2016 due to the low oil prices. Anyway, the balance sheet of the ECB is now broadening and will keep on during the period of QE due to asset purchases. Yet, there is no evidence that the monetary expansion is so effective, since the QE programme fails reaching its goals.

By Anna Aleksina
Market Analyst at the Investment Fund