The European Central Bank has left interest rates unchanged for the first time in over a year after raising the deposit rate to a record level of 4%. The message is clear: the ECB will maintain its rates at this level long enough for inflation to return to the 2% target. Speaking in Athens, where the Governing Council met for one of its regular meetings outside the ECB’s headquarters in Frankfurt, President Christine Lagarde said, “We need to be stable.” She added, “Discussing reductions is totally premature.”
Like their counterparts in the United States and the United Kingdom, the ECB has not closed the door to further rate hikes if inflation fails to ease quickly. However, at this stage, investors have remained oblivious to this idea. When looking at future expectations, they anticipate reductions starting next June, even as the region may ultimately succumb to a recession without resolving the inflation problem. Investors have been wrong all year in 2023. They could repeat this performance in 2024.
On the other hand, the ECB has other concerns to manage. President Christine Lagarde and her colleagues are seeking to reorganize the plumbing that connects the ECB to the banks. Indeed, 15 years after the collapse of Lehman Brothers ushered in the era of unconventional monetary tools and flooded the market with liquidity.
Authorities cannot go back and recreate the system that existed before. But without reform, the ECB unwinding its obligations and long-term loans, currently totalling 5.3 trillion euros, could ultimately disrupt its monetary policy mechanisms to combat inflation.
The authorities’ primary priority is to reduce a balance sheet that has expanded since the years following the global financial crisis in 2008. But lightening the balance sheet effectively means weaning the financial system off liquidity in a rising rate environment. It’s not easy after more than a decade of bad habits.
When the ECB began offering unlimited liquidity to banks in 2008, it marked the beginning of the end of a world in which banks lent money to each other rather than relying on the central bank. In the meantime, policymakers closely controlled the amount of money in the system. Large-scale bond purchases by central banks subsequently definitively ended this system. Ultimately, many officials dream of recreating the pre-crisis environment, fearing that institutions may have lost the necessary know-how to operate.
A document commissioned by the ECB estimates that banks would need reserves of around 1.4 trillion euros to operate the system. Other independent institutions, like Bloomberg, assess that the monetary base should be between 1.8 trillion and 2 trillion euros. If the ECB eventually wants to recreate the pre-crisis system, it will have to limit the amount of money provided to banks. In that case, with fewer funds available, overnight market rates would rise as banks paid higher interest for increasingly scarce liquidity.