Ecb balance sheet -
What Is Monetary Policy?
Monetary policy is a set of tools that a nation's central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation's banks, its consumers, and its businesses.
The goal is to keep the economy humming along at a rate that is neither too hot nor too cold. The central bank may force up interest rates on borrowing in order to discourage spending or force down interest rates to inspire more borrowing and spending.
The main weapon at its disposal is the nation's money. The central bank sets the rates it charges to loan money to the nation's banks. When it raises or lowers its rates, all financial institutions tweak the rates they charge all of their customers, from big businesses borrowing for major projects to home buyers applying for mortgages.
All of those customers are rate-sensitive. They're more likely to borrow when rates are low and put off borrowing when rates are high.
- Monetary policy is a set of actions that can be undertaken by a nation's central bank to control the overall money supply and achieve sustainable economic growth.
- Monetary policy can be broadly classified as either expansionary or contractionary.
- Some of the available tools include revising interest rates up or down, directly lending cash to banks, and changing bank reserve requirements.
Understanding Monetary Policy
Monetary policy is the control of the quantity of money available in an economy and the channels by which new money is supplied.
By managing the money supply, a central bank aims to influence macroeconomic factors including inflation, the rate of consumption, economic growth, and overall liquidity.
In addition to modifying the interest rate, a central bank may buy or sell government bonds, regulate foreign exchange (forex) rates, and revise the amount of cash that the banks are required to maintain as reserves.
Economists, analysts, and investors eagerly await monetary policy decisions and even the minutes of meetings in which they are discussed. This is news that has a long-lasting impact on the overall economy as well as on specific industry sectors and markets.
What Goes Into Policy Decisions
Monetary policy is formulated based on inputs from a variety of sources. The monetary authority may look at macroeconomic numbers such as gross domestic product (GDP) and inflation, industry and sector-specific growth rates, and associated figures.
Geopolitical developments are monitored. Oil embargos or the imposition (or lifting) of trade tariffs are examples of actions that can have a far-reaching impact.
The central bank may also consider concerns raised by groups representing specific industries and businesses, survey results from private organizations, and inputs from other government agencies.
Monetary authorities are typically given broad policy mandates to achieve a stable rise in gross domestic product (GDP), keep unemployment low, and maintain foreign exchange (forex) and inflation rates in a predictable range.
In addition to monetary policy, fiscal policy is an economic tool. A government may increase its borrowing and its spending in order to spur economic growth. Both monetary and fiscal tools were used lavishly in a series of government and Federal Reserve programs launched in response to the COVID-19 pandemic.
The Federal Reserve Bank is in charge of monetary policy in the U.S. The Federal Reserve (Fed) has what is commonly referred to as a dual mandate: to achieve maximum employment while keeping inflation in check.
That means it is the Fed's responsibility to balance economic growth and inflation. In addition, it aims to keep long-term interest rates relatively low.
Its core role is to be the lender of last resort, providing banks with liquidity and regulatory scrutiny in order to prevent them from failing and creating a panic.
Types of Monetary Policies
Broadly speaking, monetary policies can be categorized as either expansionary or contractionary:
Expansionary Monetary Policy
If a country is facing high unemployment due to a slowdown or a recession, the monetary authority can opt for an expansionary policy aimed at increasing economic growth and expanding economic activity.
As a part of expansionary policy, the monetary authority often lowers the interest rates in order to promote spending money and make saving it unattractive.
Increased money supply in the market aims to boost investment and consumer spending. Lower interest rates mean that businesses and individuals can get loans on favorable terms.
Many leading economies around the world have held onto this expansionary approach since the 2008 financial crisis, keeping interest rates at zero or near zero.
Contractionary Monetary Policy
A contractionary monetary policy increases interest rates in order to slow the growth of the money supply and bring down inflation.
This can slow economic growth and even increase unemployment but is often seen as necessary to cool down the economy and keep prices in check.
In the early 1980s with inflation hovering in the double digits, the Fed raised its benchmark interest rate to a record 20%. Though the high rates caused a recession, it managed to bring inflation back to the desired range of 3% to 4% over the next few years.
Tools to Implement Monetary Policy
Central banks use a number of tools to shape and implement monetary policy.
- First is the buying and selling of short-term bonds on the open market using newly created bank reserves. This is known as open market operations. Open market operations target short-term interest rates such as the federal funds rate. The central bank adds money into the banking system by buying assets—or removes it by selling assets—and banks respond by loaning the money more easily at lower rates—or more dearly, at higher rates—until the central bank's interest rate target is met. Open market operations can also target specific increases in the money supply to get banks to loan funds more easily by purchasing a specified quantity of assets. This is the process known as quantitative easing (QE).
- The second option is to change the interest rates or the required collateral that the central bank demands for emergency direct loans to banks in its role as lender-of-last-resort. In the U.S., this rate is known as the discount rate. Banks will loan more freely or less freely depending on this interest rate.
- Authorities also can manipulate the reserve requirements. These are the funds that banks must retain as a proportion of the deposits made by their customers in order to ensure that they are able to meet their liabilities. Lowering this reserve requirement releases more capital for the banks to offer loans or to buy other assets. Increasing it curtails bank lending and slows growth.
- Unconventional monetary policy has also gained popularity in recent times. During periods of extreme economic turmoil, such as the financial crisis of 2008, the U.S. Fed loaded its balance sheet with trillions of dollars in treasury notes and mortgage-backed securities (MBS), introducing new lending and asset-purchase programs that combined aspects of discount lending, open market operations, and QE. Monetary authorities of other leading economies across the globe followed suit.
- Central banks have a powerful tool in their ability to shape market expectations by their public announcements about possible future policies. Central bank statements and policy announcements move markets, and investors who guess right about what the central banks will do can profit handsomely.
What Is Monetary Policy vs. Fiscal Policy?
Monetary policy is enacted by a central bank with the mandate to keep the economy on an even keel. The aim is to keep unemployment low, protect the value of the currency, and maintain economic growth at a steady pace. It achieves this mostly by manipulating interest rates, which in turn raises or lowers borrowing, spending, and savings rates.
Fiscal policy is enacted by a national government. It involves spending taxpayer dollars in order to spur economic recovery. It sends money, directly or indirectly, to increase spending and turbo-charge growth.
What Are the Two Types of Monetary Policy?
Broadly speaking, monetary policy is either expansionary or contractionary. An expansionary policy aims to increase spending by businesses and consumers by making it cheaper to borrow. A contractionary policy, on the other hand, forces spending lower by making it more expensive to borrow money.
Depending on which is needed at the time, expansionary or contractionary policies bring inflation into an acceptable range, keep unemployment at acceptable levels, and maintain the value of the currency.
How Often Does Monetary Policy Change?
The Federal Open Market Committee of the Federal Reserve meets eight times a year. After a couple of days of discussion, it will announce whether it will make any changes to the nation's monetary policies, and, if so, what they will be.
That said, the Federal Reserve may act in an emergency if it deems it to be necessary. It has done so in recent crises including the 2007-2008 economic meltdown and the COVID-19 pandemic shutdown.
Notes on transactions not disclosed in the balance sheet (PDF, 0 MB)
By Francesco Canepa
FRANKFURT (Reuters) - The European Central Bank is coming under pressure from bankers to lend more of its stash of German government bonds to avert a market squeeze that would undo some of its own stimulus efforts.
As the safest debt in the region, Germany's sovereign bonds are the lifeblood of European financial markets and the most coveted collateral for guaranteeing trades at clearing houses.
But there aren't enough of them to satisfy demand in the 8.3-trillion-euro ($9.3 trillion) market for repurchase agreements, or repos, where investors swap cash for bonds.
This is because the ECB - mostly via Germany's Bundesbank - has hoovered up nearly a third of German public debt in an effort to support the euro zone economy since 2015 and, with renewed impetus, during the COVID-19 pandemic.
Having drained the markets with its multi-trillion-euro debt-buying programmes, the ECB has left fewer bonds sitting on dealers' balance sheet and available to be borrowed on the repo market.
Investors are currently paying 0.99% to borrow German bonds against cash for two months, implying a 7% rate for bonds lent on Dec. 31 for the following Monday, data on Refinitiv Eikon shows. Borrowing the debt for two months cost 0.6% two months ago.
So bankers are clamouring for the ECB, and particularly the Bundesbank, to lend more of its bonds to avert a drought which would cost them dearly and might even push some into default.
"If a major bank or fund cannot meet its obligation towards a central clearing counterpart, the CCP must place it in default which triggers defaults at all other CCPs," said Godfried De Vidts, a senior advisor to the International Capital Market Association trade body.
Ironically for the ECB, the shortage of German bonds available to be borrowed risks causing funding markets to seize up, making credit more expensive and going against the spirit of the central bank's easy-money policy.
German bonds trade at their highest premium to swaps since the height of the pandemic and spreads on corporate bonds have started two widen, albeit from very tight levels.
Squeeze building in German bonds: https://fingfx.thomsonreuters.com/gfx/mkt/jnpwexnoqpw/Squeeze%20building%20on%20German%20bonds.png
This could turn into a headache for the ECB as it weighs how to wind down its pandemic-fighting programme in December without upsetting financial markets.
"If I were working at the ECB, given the lack of monetary policy levers available to me, I'd make sure the market is as little distressed as possible," Peter Chatwell, a strategist at broker Mizuho said.
The issue has been bubbling in the background for years but it has blown out in recent days on investor concern about a German bond pinch around year-end when issuance falls and banks shrink their balance sheets to meet regulatory demands.
The ECB doubled the amount of bonds that the 19 central banks of the euro zone can lend against cash to 150 billion euros from 75 billion euros last week.
But analysts say this is not solving the problem because banks are running against a constraint on how many bonds they can borrow.
This is a safeguard that central banks have in place to minimise the risk they take and to incentive borrowers to turn to the market instead.
"The counterparty limit is the real problem," Giuseppe Maraffino, a fixed income strategist at Barclays Investment Bank, said.
"If we were to see more transactions failing, we think the Bundesbank and the other euro area central banks could consider raising the counterparty limit, at least
Credit is more expensive even for the safest companies: https://fingfx.thomsonreuters.com/gfx/mkt/zgvomkgxwvd/Spreads%20widening%20even%20for%20safest%20borrowers.png
($1 = 0.8909 euros)
(Reporting By Francesco Canepa; Editing by Emelia Sithole-Matarise)
Understanding the expansion of central banks’ balance sheets
Note: the bulk of French public debt held by the Eurosystem is held by the Banque de France, and the remaining amount by the ECB.
Another possible limit is the risk of loss for central banks in the event of a deterioration in the creditworthiness of the issuers of the securities held, or that of institutions benefiting from bank refinancing. However, this risk is kept under tight control: i) the scope of the purchase programmes is restricted to assets deemed to be low-risk; ii) in practice, securities are held until maturity, thus shielding the Eurosystem from the risks related to bond price fluctuations; and iii) the refinancing operations are subject to a collateral policy. Furthermore, a possible contingency would be a rise in key interest rates, which could lower profits or even cause losses for the Eurosystem due to its immediate impact on the remuneration of liabilities (reserves), while the Eurosystem holds long-term assets with fixed rates (securities held to maturity and long-term refinancing). To face this risk of loss, central banks make provisions. As a last resort, they could be recapitalised by governments. In principle, central banks could even temporarily operate with negative equity, but in practice this would undermine their credibility and independence and could trigger a loss of confidence in the currency and ultimately uncontrolled inflation (Barthelemy and penalver (2020)).
What is the outlook?
The size of the Eurosystem's balance sheet is likely to remain at a high level for the foreseeable future. On the one hand, a significant share of the assets purchased are long-term securities. On the other, the Eurosystem has announced the reinvestment of principal payments from maturing securities, at least until end-2023 in the case of the PEPP, and as long as necessary to maintain a high degree of monetary support in the case of the APP. In the longer term, however, the Eurosystem's balance sheet is expected to stabilise and then gradually decline once inflation has lastingly returned to close to its target. Moreover, a large balance sheet would not prevent the central bank from raising key interest rates if it deemed it necessary: it would ensure their transmission to market rates via the interest rates remunerating commercial banks’ excess reserves, which remains a floor for the interbank interest rate despite the abundance of liquidity.
Without prejudging the average level of the balance sheet that is desirable in the long run, the fact remains that "balance sheet policies" have found their place in central banks’ toolbox. If the room for downward manoeuvre on interest rates remains limited in the future, adjustments to the size of balance sheets will continue to be a useful tool for responding to possible negative shocks to inflation (see CGFS (Potter and Smets, 2019), or Bernanke (2020)).
Germany Doesn't Seem To Care That Europe Is On The Brink Of A Continent-Wide Recession
The European economy is slowing down, and there is a danger of both a new recession and deflation across the continent. The ECB has already made money as cheap as possible for investors to borrow by holding interest rates down close to zero. QE would be the next step — a programme in which the ECB buys various assets from banks largely to inject new cash into the system.
Germany, once the economic powerhouse of the continent, is itself teetering on the brink of contraction — and yet the Germans don't seem to want to do anything about it. Weidmann, speaking to Handelsblatt, a German business newspaper, said the Germans would prefer to be debt-free:
"Such purchases might create new incentives to run up debt, besides adding to the reform fatigue in a number of countries," he cautioned. Nor was there any guarantee that quantitative easing would indeed have the intended impact on the economy, Weidmann pointed out.
He added that Germany shouldn't offer Europe a stimulatory boost with fiscal policy — i.e. government spending — either. Germany could easily boost its government spending and stay within the reasonable debt cap of 3% of GDP. But that ain't happening:
Calls for Germany to increase its investment to help its partners amounted to nothing more than a plea for a common fiscal policy, he asserted. For another thing, Weidmann pointed out, such expenditure would do little to help countries on Europe's periphery.
ECB president Mario Draghi has hinted that the ECB will go for QE. BNP Paribas, Deutsche Bank, and Bank of America expect that the purchases of government debt will start in 2015.
Draghi's continued insistence that the ECB will add about €1 trillion ($1.25 trillion) to its balance sheet would probably need full QE. The bank is already buying some bonds and securities, but the markets in those assets are probably too small to reach such a big goal.
The ECB could push for QE without Weidmann, but it's previously been keen to get unanimous decisions, so as not to alienate big European economies like Germany. These sort of comments might make some analysts rethink the likelihood of QE for Europe.
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