FRANKFURT — When the global financial crisis struck in 2008, panicked central bankers desperate to stop the system collapsing and avoid deflation did the unthinkable: they threw out their operating manuals and cranked up the money printers to unprecedented levels.
In the process they created a whole new central banking paradigm, known in the industry as an “abundant liquidity” operating framework. That abundance became even more pronounced when the pandemic struck, forcing the money presses to run even hotter.
But now, with the return of inflation, that paradigm has become a liability. It badly needs replacing. The question preoccupying central banking minds, however, is with what?
Dusting off the old framework and simply slotting it back into place is not an option. Money printing has had too deep and distorting an impact.
That’s why the European Central Bank, for one, has been thinking hard about how to reconfigure itself by way of a formal operational framework review it initiated in late 2022.
While it’s already taken longer than planned and the ECB still hasn’t committed to anything specific, the landing zone is now coming into view. Two weeks ago, the Eurosystem’s operations guru, Tuomas Välimäki, spelled out his thoughts in a speech, complementing previous remarks by head of markets Isabel Schnabel and chief economist Philip Lane. The three are among the most influential officials in the discussions — an operational ‘Holy Trinity’ to set out future doctrine.
From demand-driven to supply-driven — and back again
The original operational framework, which Välimäki co-authored back in the 1990s, had policymakers deliberately keeping the system short of reserves to force banks to borrow the necessary shortfall from the ECB, at a rate that fluctuated gently within a firmly defined range, or ‘corridor’. The system relied on an active interbank market distributing central bank liquidity to the banks that required it. Because the banks needed what only the central bank could give, it was a system driven, at the margins, by demand.
The great financial crisis put an end to that: banks’ trust in each other evaporated, forcing the central bank to push huge amounts of liquidity into the system. In other words, the supply of reserves, rather than demand for them, became the dominant factor. As it did so, the ECB’s most important rate became the one at which banks could deposit their excess reserves, the Deposit Rate.
Vast ‘excess’ liquidity all-but banished the twin threats of financial collapse and deflation, but it also made it easier for inflation to take root. The interbank market, once a reliable guide to banks liquidity needs, shrivelled to insignificance.
With inflation, rather than deflation, now the bigger threat, that excess liquidity has to be reduced. The ECB has already started down that path: its total assets have fallen by more than a fifth since peaking at €8.79 trillion in mid-2022.
But that process creates new problems. At some stage, liquidity will start becoming scarce again. And that means the return of bank collapse risk or, at the very least, the kind of financial market volatility that can hurt the real economy.
To make things worse, as Schnabel pointed out, it is impossible to know in advance when this moment will come. Bank behavior (or ‘liquidity preferences’, as the jargon has it) and bank regulation have changed since 2008, both factors leading banks to need more liquidity than they did in the past. But how much more, well, that’s anyone’s guess — a point that all three of the Holy Trinity (and the Bank of England and Federal Reserve) agree on.
You can’t always get what you want
The uncertainty may be common to all, but it accentuates one problem specific to the euro area. Unlike the U.S. and U.K., liquidity in the eurozone tends to end up in national siloes rather than flow frictionlessly across borders, as it would do in an ideal monetary union. In the past, especially in time of stress, this has led to short-term interest rates varying from country to country, generally to the benefit of Germany and other ‘core’ countries. Various types of banks also suffer, especially smaller, plain-vanilla lending and deposit-taking institutions. The ECB’s single monetary policy is not transmitted evenly. Välimäki and Schnabel have both drawn attention to this risk.
The answer, they argue, is in reviving a system that is at least partly ‘demand-driven’, where banks that need liquidity can be sure to get it through regular lending operations. These, according to Lane, could be divided into short-term operations, which would guard against any sudden surge in bank demand for reserves, and longer-term ones, which could be used to give banks the capacity to fund their less liquid assets, or to extend longer term loans.
Välimäki signaled that the shorter-term operations should continue under the mechanism known as ‘fixed-rate, full allotment’, letting banks borrow as much as they like at a fixed price, against adequate collateral. This has the advantage of offering maximum control over short-term money-market rates, he argued. The longer-term ones, he added, should be offered at competitive auctions, to keep the pricing consistent with signals from public funding markets.
Välimäki highlighted that the Bank of England has already taken steps toward this kind of system, through a ‘short-term repo’ facility (STR), which aims to smother any volatility that arises as it gropes its way back to a new ‘steady state’, and an ‘index-linked term repo’ facility (ILTR), which lends against a broader set of collateral.
“The BoE’s framework includes some elements that I think might also be well suited to the Eurosystem,” Välimäki said.
But — you’ll get what you need
One of the problems of a ‘demand-driven’ system, however, is that banks’ reliance on such operations became a distress signal during the last crisis. For the new system to work, the stigma usually attached to using lender-of-last-resort facilities would also have to be eliminated, Välimäki said.
The U.K. has tried to do that by tweaking regulation to avoid stigmatizing banks for using those facilities. The BoE prices both STR and ILTR at the Bank Rate, to signal there is no penalty for using them.
A framework that ensures banks can always ‘get what they need’ (as long as they have enough collateral) ought logically to make for calmer heads in a crisis, making bank runs less likely and acting as a circuit-breaker when confidence starts to waver.
If the ECB can succeed in changing mindsets that way, it will have removed an incentive for banks to hoard liquidity in the first place, allowing its balance sheet to shrink more, Lane argued.
Toward a ’structural bond portfolio’
Whether market attitudes can be shaped so easily is still an open question. While the BoE’s new framework has drawn plaudits from many sides, its two key facilities are still largely untested since the BoE — like the ECB — still operates in an environment of substantial excess liquidity.
That’s one reason why all three of the Trinity see the ECB continuing to supply at least the longer-term part of banks’ reserve demand through bond purchases, something they call a ‘structural portfolio’.
How big that portfolio should be, and what should and should not be held in it, are still a subject of intense debate. But its very existence, which some fear might be interpreted as facilitating money-printing by the backdoor, will be a permanent scar on the economy from the battles of the money-printer era, and a reminder that central banks — for centuries just the backstop to a free-functioning market — have become a permanent and distorting presence in it.
