The ECB’s Deposit Facility and its Guard Against Inflation – Euro Thoughts Sep. 21-25, 2009 – UniCredit Group

Last week, we have shown how the current situation in the eurozone banking system is one of a large liquidity surplus, and that the increase in excess reserves – the sum of pure excess reserves and deposits held at the ECB – has been sizeable and to be ascribed almost entirely to the ECB’s policy on liquidity. Critics of the ECB’s approach claim that sooner or later, this huge amount of liquidity injected into the system will result in spiraling inflation that will force the central bank to raise rates aggressively. We have already exposed the reasons that lead us to think that there is no inflation spike in sight in the euro area. The single and most important thing is that the ECB’s “credit easing” policy is chiefly carried out via repo operations that will unwind automatically – with the ECB getting the money back and the bank the collateral provided – once the central bank will think that the system no longer needs emergency measures.

However, it is on a more particular and technical aspect that we would like to concentrate our attention in this brief note: the functioning of the money multiplier in the eurozone and the real inflation potential that ECB measures adopted so far embed. Money and banking textbooks teach us that an increase in bank reserves should be “multiplied” into a much larger increase in the money supply as banks expand their deposits and lending activities. The expansion of deposits, in turn, should raise reserve requirements until there are no excess reserves in the system. Clearly, this process is currently not at work in the euro area. The theory of the money multiplier postulates that banks do not earn interest on their excess reserves at the central bank. In such an environment, a bank holding excess reserves will prefer to lend that money at any positive interest rate. Additional lending will result in lower short-term interest rate and will create additional deposits in the system, thus leading to a small increase in the compulsory reserves. However, the increase in reserve requirement is only a small fraction, so the supply of excess reserves remains large. Hence, the process goes on, with banks lending more and the short-term interest rates falling further.

The multiplier process ends when one of two things happens: 1) it can go on until there are no more excess reserves in the system, i.e. until the increase in loans and deposits has raised obligatory reserves up to the level of total reserves. In this case, the money multiplier is fully working. The only case where the multiplier would stop functioning is when the short-term rate reaches zero. In that case, banks no longer bear the cost to hoard excess reserves and would prefer to stop lending. 2) The second case where the money multiplier doesn’t work or works only partially is when the central bank pays an interest on excess reserves. When reserves are remunerated, the process stops sooner, how sooner depends on the rate itself. Indeed, in this case, the process stops when the market rate reaches the level at which banks’ reserves are remunerated. If the central bank remunerates reserves at the same level of its target rate, then the money multiplier disappears. In the ECB operational framework, excess reserves almost completely consist of the deposit facility (in August “pure” excess reserves were EUR 900mn whereas the deposit facility averaged EUR 160bn) which is remunerated.

Hence, beyond the precautionary motive that currently leads banks to deposit large sums at the ECB, it has to be said that the central bank’s operational framework has always prevented the money multiplier effect from being fully operational. Plus, it may appear redundant, but it has to be remembered that the current very large excess reserves of the Eurosystem were not created with the goal of lowering the short-term interest rate or increasing bank lending significantly to pre-crisis levels. Certainly, the ECB has prevented a full-fledged credit crunch and the fact that growth in lending to the private sector remains positive has to be considered a great achievement. These reserves have to be considered mainly a byproduct of the lending policies designated by the ECB to face market disruptions. Hence, no surprise that the money multiplier is not working.

Let’s now focus on the concern that these excess reserves will result in accelerating inflation unless the ECB acts to remove them quickly, once the recovery starts – hence pretty soon if we agree that from 3Q onwards the euro area will resume positive growth. Our belief is that inflation worries would be justified in a more theoretical environment, but not in the Eurosystem where the ECB pays interest rate on the deposit facility. When the recovery gains momentum, loan demand from firms will increase, and banks – no longer afflicted by liquidity and de-leveraging problems – will ease their lending standards. Loans will increase, so will do deposits and the money multiplier process will start again. True, left unchecked this growth in lending and in aggregate demand would prove inflationary. However, paying an interest on reserves breaks the link between the amount of reserves and the banks’ propensity to lend. By increasing the deposit rate – the ECB could even think to narrow for a while the corridor if it doesn’t want to act on the refi rate too soon – the central bank would contribute to increase market interest rates, thus slowing the growth in monetary aggregates. The path of the short-term interest rates would be independent of the level of the reserves. Hence, inflationary pressures may remain in check even if systemic financial conditions will continue to justify a high level of reserves. It will be the deposit facility that will save us from the inflation spectre.