The September policy package

Prepared by Julian Schumacher and Ine Van Robays

Published as part of the ECB Economic Bulletin, Issue 6/2019.

At its September meeting, the Governing Council faced a more protracted slowdown of the euro area economy than previously anticipated, persistent and salient downside risks and a further delay in the convergence of inflation towards its medium-term inflation aim. The outlook for inflation has continued to fall short of the Governing Council’s aim on the back of slower euro area growth dynamics. Inflation rates, both realised and projected, have failed to pick up in recent months, measures of underlying inflation have remained generally muted, and market and survey-based indicators of long-run inflation expectations stand at historically low levels. This picture is also reflected in the latest ECB staff macroeconomic projections for the euro area, which show a further downgrade of the inflation and growth outlook.

In the pursuit of its mandate to deliver price stability in the euro area, the Governing Council adopted a substantial package of monetary policy measures. The package consists of five elements: (i) a cut in the interest rate on the deposit facility, (ii) adjustments to the forward guidance on the key ECB interest rates, (iii) the restart of net purchases under the asset purchase programme (APP), (iv) modifications to the modalities of the new series of targeted longer-term refinancing operations (TLTRO III), and (v) the introduction of a two-tier system for reserve remuneration. These measures complement each other in providing substantial monetary stimulus. They will lock in financial conditions across various segments of the market that are sufficiently supportive to foster a reacceleration of growth and the anchoring of inflation expectations. They preserve favourable bank lending conditions and also support the smooth transmission of the accommodative monetary policy stance to the real economy.

First, the Governing Council decided to lower the interest rate on the deposit facility to -0.50%. In an environment of excess liquidity, the deposit facility rate is the anchor for short-term interest rates, which in turn underpin the monetary policy transmission mechanism. The interbank market rate (EONIA) anchors the overnight index swap curve in the euro area, which underlies the pricing of many financial instruments and, in particular, the reference rates that are important for loan rate fixation. Reductions in the deposit facility rate thus provide monetary policy stimulus across the entire term structure of interest rates, which constitutes the basis for funding costs for businesses and households. Lowering the interest rate on the deposit facility by 10 basis points therefore adds further accommodation and, in addition, encourages banks to lend to the economy instead of holding on to liquidity, which should support the portfolio rebalancing channel of the APP.

Second, the Governing Council provided a clear signpost for the future path of short-term interest rates by amending the state-based element of its forward guidance. The adjustments complement the Governing Council’s emphasis on symmetry in its inflation aim that it had stressed at its July meeting, underlining its determination to act in the face of inflation running below the definition of price stability with the same commitment as with inflation running above it. The September meeting provided further clarifications of the forward guidance.

The Governing Council has now strengthened the state-based element of its forward guidance by linking it to a more stringent set of conditions for the inflation outlook. These enhancements clarify the reaction function of the Governing Council with respect to developments in the inflation outlook. In particular, the Governing Council now expects the key ECB interest rates to remain “at their present or lower levels until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within our projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics.” The reference to levels “sufficiently close to, but below, 2%” signals that the inflation outlook has to increase significantly from its current realised and expected levels, and that the convergence of the inflation outlook will need to be observed within the projection horizon. Moreover, the inflation outlook will have to converge in a robust manner, meaning that the Governing Council wants to be sure that the process of convergence is sufficiently mature and realistic before starting to lift policy rates. The qualification that convergence must be reflected in underlying inflation dynamics ensures that the trajectory of realised inflation should underpin the inflation outlook. These elements provide a safeguard against reacting too strongly to transitory inflation shocks, as well as to forecast and measurement errors.

The strengthened forward guidance underlines the Governing Council’s commitment to maintain a highly accommodative stance for as long as needed for inflation to sustainably reach levels around its medium-term aim. In addition, the Governing Council indicated that interest rates could be reduced further if warranted by the inflation outlook, thus retaining an “easing bias” on policy rates.

Third, the Governing Council decided to restart net purchases under its APP at a monthly pace of €20 billion, and will continue to reinvest for an extended period of time. Renewed net asset purchases will keep a lid on long-term rates by compressing risk premia. At the same time, the Governing Council decided to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period after the date when interest rates are raised, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation. The Governing Council also decided to extend the possibility of purchasing assets with yields below the deposit facility rate, to the extent necessary, to the private sector parts of the APP, namely the third covered bond purchase programme (CBPP3), the asset-backed securities purchase programme (ABSPP) and the corporate sector purchase programme (CSPP). This extension will facilitate the continued smooth implementation of the APP and reflects changes in market interest rates relative to the deposit facility rate.

Resuming net asset purchases will complement the impact of the forward guidance on interest rates, as they are expected to run for as long as necessary to strengthen the accommodative impact of the policy rates and to end shortly before interest rates are raised. This enhances the signalling role for policy rates. Since the state-based element of the forward guidance on the ECB’s key interest rates is based on developments in projected inflation and the trajectory of underlying inflation, it makes the horizon for net purchases contingent on the inflation outlook. Furthermore, linking the reinvestment policy to interest rates also ensures that the reinvestment horizon moves together with the expected path of interest rates, thereby strengthening the latter’s accommodative impact.

Fourth, the Governing Council decided to adapt the modalities of TLTRO III. The pricing of the new operations has been made more attractive. In particular, the 10-basis point spread over the entry and minimum borrowing rates announced in June has been removed. The interest rate in each operation will now be set at the level of the average rate applied in the main refinancing operations over the life of the respective TLTRO III operation. Banks that lend more than a specified benchmark will be offered a lower rate, which can be as low as the average interest rate on the deposit facility. The new pricing will support bank funding conditions to ensure that banks continue to offer favourable lending conditions to firms and households. Furthermore, the maturity of the TLTRO III operations has been prolonged from two to three years to better align their length with the typical maturity of bank-based financing of investment projects. This enhances the support that TLTRO III will provide to the financing of the real economy. Finally, counterparties will have the opportunity to make voluntary early repayments of the borrowed amounts at a quarterly frequency starting two years after the settlement of each operation. Together, these modifications will preserve favourable bank lending conditions, ensure the smooth transmission of monetary policy and further support the accommodative stance of monetary policy.

Finally, the Governing Council decided to introduce a two-tier system for reserve remuneration, in which part of banks’ holdings of excess liquidity are exempt from the negative deposit facility rate. The Governing Council has been closely monitoring the possible side effects of negative interest rates on bank-based intermediation, which can become more prominent the longer negative rates are in place and the lower they are. In this regard, a two-tier system will help to preserve the positive impact of the negative interest rate policy on the economy by offsetting some of the direct impact on bank profitability. The maximum volume of reserve holdings in excess of minimum reserve requirements that will be exempt from the deposit facility rate – the exempt tier – will be determined as a multiple of credit institutions’ minimum reserve requirements. The multiplier, which will be applicable as of the seventh maintenance period of 2019, will be set at 6, and the exempt tier will be remunerated at an annual rate of 0%.^[1] The remuneration rate of the exempt tier and the multiplier to determine its maximum size can be changed over time, based on money market conditions. With current liquidity conditions,^[2] the exempt tier could amount to 43% of excess liquidity holdings if credit institutions make full use of their exempt allowances. This will support the bank-based transmission of monetary policy, thereby enhancing the effectiveness of the negative interest rates policy in the pass-through of low policy rates to bank lending rates.

This comprehensive policy package will support the convergence of inflation to the Governing Council’s medium-term aim. Through each of the policy measures and their mutually reinforcing impact, the September policy decisions will provide substantial monetary stimulus to ensure that businesses and households can continue to borrow at very attractive rates. The favourable financing conditions will underpin the economic expansion by supporting consumption and investment dynamics which, in turn, will support the convergence of inflation to the Governing Council’s aim.

In any case, the Governing Council reiterated that it continues to stand ready to adjust all of its instruments, as appropriate, to steer inflation towards its aim in a sustained manner. A highly accommodative stance of monetary policy will be needed for a prolonged period of time. The September policy package underscores the Governing Council’s determination and readiness to provide the necessary accommodation in the pursuit of its price stability objective. If the inflation outlook continues to linger at levels well below its inflation aim, the Governing Council continues to be prepared to use all of its instruments, as appropriate, to ensure that inflation converges sustainably to its aim of close to, but below, 2% in the medium term, in line with its commitment to symmetry.