A new LTRO for the ECB

This post in pdf can be found here : LTRO-ECB-PW-24-09-2013

During the Questions and Answers session at the European Parliament, Mario Draghi has spoken of the possibility of a new LTRO. LTRO (Long-Term Refinancing Operation) is a tool that the ECB can use to increase liquidity to the banking sector. Usually these operations are short-term but the ECB has already made 3 year operations. It’s a long-term swap where the ECB provides liquidity against collateral. The specificity is that it’s a full allotment operation at a defined interest rate. Its consequence is to provide a large amount of liquidity to the money market (for precisions see here page 9 box 1)

There are five reasons that can explain this operation

1 – After Bernanke’s announcement on the change in US monetary policy last spring, US interest rates went up. That was also the case for the Euro Area interest rates even if during this period the ECB president has explained that ECB interest rates will remain low for an extended period. This spillover from the US to the Euro Area can be perceived as a loss of independency for the latter. In other words, the business cycle is different in the US and in Europe but in fact the change in monetary policy is driven by the Federal Reserve. We can imagine Mario Draghi’s reaction to regain autonomy. I have developed this point here in a post last week. The ultimate target is to keep the interest rates structure as low as possible to boost the recovery

2 – A larger amount of liquidity could hold down interest rates on the money market during the period of the operation. It could be perceived as Mario Draghi’s way to write guidance on interest rates. It’s a different equation than what has been done on by the Federal Reserve and the Bank of England for which guidance relies on a level of unemployment rate. These two central banks will start thinking of changing their interest rates when the unemployment rate will converge to a specific threshold. The ECB cannot have this kind of target as its objective is unique and is inflation. So Draghi could find a way to create guidance through the LTRO.

The issue is to change investors’ expectations on what will be ECB monetary policy in the future.

3 – Excess liquidity is lower than it used to be. One important target the ECB had on the money market was to reduce its fragmentation. With former LTROs the central bank has succeed in reducing this fragmentation and one tool was the excess liquidity. The ECB will not take the risk of discontinuity on the money market. A new LTRO would allow increasing liquidity and improving the defragmentation of the money market in order to improve its behavior.

4 – Money markets’ specialists expect a new LTRO to replace the old one which is still working but will stop at the beginning of 2015. And they say that this has already an impact on interest rates’ futures. They think that with no new operation this could create a discontinuity on the money market in 2015. This would be a negative shock that could have a persistent impact on financial markets (see here). The new LTRO could help to converge to a more balanced situation in the future. These specialists think that in 2015 the situation will not be balanced yet.

5 – This operation could also help banking sectors in Spain and Italy. It could improve banks’ balance sheet by transferring “weak papers” to the ECB during the time of the LTRO. We can expect that this could give time to these sectors to improve their balance sheets and to the economy to find growth at the end. If the LTRO is for three years we can expect that improvements will take place during this period.
On another point, banks in these countries and in other peripheral countries have a large amount of public debt on their balance sheets. Having liquidity could smooth their situation if there is another problem on public debt. That’s an issue that cannot be exclude.

The contagion of US interest rates on Euro Area interest rates has gone too far. The Euro Area still needs very low-interest rates as its growth momentum is still weak. For that, Mario Draghi must commit to change investors’ expectations by showing his autonomy to manage monetary policy. A new LTRO can be the solution. This could be a tool to maintain low-interest rates that could at the end improve European economic prospects.

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