September will be an important month for the European Central Bank. The organization’s meeting this Thursday will end with another interest rate cut, but there will be an event that will occur in the eurozone on September 18 that will mark a before and after in the monetary policy of the eurozone. The ECB will change two of the three reference rates it uses, in an attempt to make its monetary policy more effective. The marginal credit facility and the refinancing rate will be adjusted downwards, to get closer to the most important interest rate for the organization: the deposit facility. This interest rate has been very misunderstood in recent years, although it has surpassed in importance the other two rates used by the ECB. Why is the deposit facility now the most important policy rate on the money market? What does the ECB intend to do with the change it is going to make? The answer to these two questions helps us understand the fundamental change that the central bank is preparing.
In the tangle of unfamiliar concepts with convoluted names used by the ECB, understanding the three interest rates that the organization uses as a reference allows us to understand a little better the monetary policy of the eurozone, one of the tools used by European institutions that most affect the economy and citizens.
The ECB’s toolbox includes very different instruments. Throughout its history, the organization has used weapons of all kinds to be able to achieve its objective, from reference interest rates, to rescue tools for an entire country, to temporary bond-buying programs with which the body manipulates financial markets, with the aim of ensuring that the financial conditions of the economy match the needs. All this, with the aim of fulfilling its raison d’être, the mandate for which the ECB was created, which is nothing other than achieve stable inflation of around 2% per year.
How do central bank interest rates work?
The ECB rates are the references that the organization uses to influence the interest that the financial system, that is, the banks, charge citizens to borrow money. Commercial banks are linked to these reference levels, so that financial institutions pass on to their clients the changes that occur in the ECB rates. This is one of the most important means that the central bank has to influence the amount of money in circulation in the economy and, therefore, the existing financial conditions.
With these tools, the body chaired by Christine Lagarde has the power to decide whether the cost of debt for businesses and families increases or decreases, and uses reference rates to try to raise inflation, when it is well below the 2% target. or to try to lower it when it exceeds this level. If inflation is low, the ECB cuts reference interest rates; banks pass this reduction on to their customers, and by charging less interest on credit, this generally leads to increased demand for debt (mortgages, loans, etc.) from citizens and businesses. Thus, more money enters the system and inflation is pushed up. If inflation is high and the ECB wants to moderate it, it does the opposite: it raises rates, credit becomes more expensive and demand for loans decreases, which cools the economy and inflation.
In this sense, The ECB uses three different types: the marginal lending facility, the main refinancing rate and the deposit facility. The first two, the marginal credit facility and the refinancing rate, are very similar; they were considered the ECB’s main rate because they measure the interest that banks pay to the central bank for borrowing money. The marginal credit facility measures the interest paid in one day and the refinancing rate in one week.
The deposit facility is different, since it measures the interest paid by the ECB to banks that leave their money parked at the central bank. When a bank has excess liquidity, it brings this money to the central bank, and the agency pays the entity the interest established by the deposit facility. Logically, the refinancing rate and the marginal credit facility were always higher than the deposit facility (otherwise, a bank could borrow from the ECB at a single interest rate and automatically make a profit by lending that same money to the central bank itself).
A fundamental change in the system
In recent years, the credit market and the ECB rates have undergone significant changes. In the past, the central bank had the market very tied to the refinancing rate and the marginal credit facility (remember what the ECB charges to lend money to banks). However, starting in 2015, one factor was decisive for banks to change their dynamics and stop going to the ECB for liquidity.
In those years, the ECB needed to boost low inflation, which remained constantly below the 2% target, and to do so it began to flood the European monetary market with a new mechanism, massively purchasing public and private debt; it did so with debt repurchase programs called “QE” (Quantitative Easing), copying those already implemented by the US Federal Reserve and the Bank of Japan.
Because there was excess liquidity in the system, banks stopped going to the ECB. When they needed credit, they lent it to each other at a lower price than the central bank asked them to, and they used the deposit facility as a benchmark. Gradually, the other two types began to fall into oblivion (as did the ECB’s role as a direct liquidity provider to banks), and the deposit facility became the most important benchmark in the market. The behaviour of Euribor is the best example: while it used to be close to the refinancing rate, over time it has become more attached to the deposit facility.and the latter became the most relevant interest rate in the eurozone, the one that had to be monitored more closely to understand the credit conditions (tighter or more lax) that existed in the system.
ECB changes interest rate rules on September 18
Last March, the ECB completed its review of the operational framework and announced several measures that would involve changes in interest rates. On September 18, the central bank explained, the difference between the deposit facility and the other two types, the refinancing facility and the marginal credit facility, would be reduced. The central bank’s objective, as it itself acknowledged, was clear: to regain control of short-term interest rates in the market.
The ECB’s idea is to encourage banks to stop lending to each other with this change, and to return to their counters in search of credit. After all, reducing the gap between the deposit facility and the other two types would encourage banks to turn to the central bank again, since the conditions would be more attractive than in the past. The ECB itself acknowledged in its official statement that it intended to “encourage banks to bid on weekly operations” so that “market interest rates move close to the deposit facility.”
From September 18th the refinancing rate will be lowered to 15 basis points above the deposit facility (now the spread is 50 basis points); The marginal credit facility, meanwhile, will be left at 25 basis pointscompared to 75 currently. The floor price of money will continue to be set by the deposit facility, the one that has been used in recent years as a benchmark for the market. This Thursday, six days before the change, the ECB meets at its monetary policy meeting, during which it is expected to cut rates, and the level at which it will leave the deposit facility will mark Where the other two benchmarks remain from the 18th.
