Use of ECB’s deposit and marginal lending facilities

In 9 October 2008, the ECB reduced the corridor of standing facilities from 200 basis points to 100 basis points around the interest rate on main refinancing operations. The rate of the marginal lending facility was reduced from 100 to 50 basis points above the interest rate on the main refinancing operation, while the rate of the deposit facility was increased from 100 to 50 basis points below the interest rate on main refinancing operations. The corridor was increased back to 200 basis points in January 2009, but again reduced to 150 basis points in May 2009. As of October 2012, the corridor stood at 150 basis points.

As described in section 2.2.2, if interbank markets function smoothly and risks related to interbank lending are small, banks should have no incentive to use deposit and marginal lending facilities. Figure 9 shows the evolution of deposit and marginal lending facilities set up by the ECB from 2007 to the beginning of October 2012.

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Figure 9. Deposit and lending facilities (in billions of euro). Data source: ECB Statistics The left hand side of figure 9 reveals that overnight deposits at the ECB were close to zero before the collapse of Lehman Brothers. After that, deposits at the ECB have considerably increased. In early stages of the crisis, the observation is most likely consistent with risk aversion; when perceived creditworthiness of counterparties is low, banks may choose not to participate in interbank lending. As a result, it seems that a large part of excess reserves has been deposited at the ECB. In later stages of the crisis, overnight deposits have increased substantially particularly after the ECB conducted two 36 month LTROs. This observation could indicate both risk aversion and a lack of demand for money in the interbank market. By conducting two 36 moth LTROs the ECB flooded the interbank market with liquidity with an amount that is most likely much more than is demanded by banks to solely fund their positions.

The right hand side of figure 9 shows that the use of ECB’s marginal lending facility has been quite moderate during the crisis, despite a few spikes in 2009 and 2011. As the marginal

48 3.5.3. Inflation expectations

As unconventional operations of the ECB have grown, it is a natural that some market participants may become worried about future inflation because there is a well-documented long run empirical relationship between broad money (M3) growth and inflation, as already mentioned in section 2.4. However, the excess liquidity in the financial system may not necessarily produce inflation as banks may choose to hold a significant amount of excess reserves in order to protect themselves from future liquidity shortages.²⁰ If banks choose not to lend out a significant part of the excess liquidity, inflationary pressures may be limited as credit creation process is not fully initiated.

According to the ECB (2012), developments in longer term inflation expectations play an important role in central banks’ monitoring and assessment activities, because well-anchored expectations are central to the functioning of the monetary transmission mechanism. The ECB monitors long term inflation expectations derived from surveys and financial market instruments. The focus is on longer term rather than shorter-term expectations, because inflation in the short term can be heavily affected by shocks, such as commodity price developments or changes in indirect taxes. Longer term inflation expectations should be a more fundamental measure of expectations about the credibility of monetary policy.

Market-based indicators of longer term inflation expectations are derived from inflation-linked bonds and inflation-inflation-linked swaps. According to the ECB (2012), for the purpose of monitoring longer-term inflation expectations, the five-year inflation-linked swap rate five years ahead is used as one of the most suitable indicator.²¹ It measures the expected inflation for a five-year period starting in five years and is therefore not affected by short-term shocks as much as spot five-year inflation swaps are. As a result, five-year forward inflation swap rates are more much more stable than five-year spot inflation swap rates. Figure 10 shows

20 The ECB defines M3 to include (1) currency in circulation, (2) overnight deposits, (3) deposits with an agreed maturity of up to two years, (4) deposits redeemable at notice of up to three months, (5) repurchase agreements, (6) money market fund shares and units and (7) debt securities with a maturity of up to two years. Definition available at: http://www.ecb.int/stats/money/aggregates/aggr/html/hist.en.html

21 In an inflation swap, one party pays a fixed rate on a notional principal amount, while the other party pays a floating rate linked to an inflation index, such as the Consumer Price Index (CPI). Just like plain vanilla interest rate swaps, the fixed rate in an inflation swap therefore provides information on private sector expectations of future inflation.

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how inflation expectations derived from forward inflation swaps have evolved from 2007 to the beginning of October 2012.

Figure 10. Eurozone 5y5y inflation expectations. Data source: Bloomberg

Interpretation of figure 10 is that, for example on 30 September, market participants expect that the average annual inflation between 30 September 2017 and 30 September 2022 will be slightly below 2,4 %, as the last observation in the series indicates.

According to figure 10, long term inflation expectations have been quite well anchored to the 2 % inflation target during the financial crisis despite worsening economic outlook in Europe.

It seems that long term inflation expectations did slightly rise after the ECB announced that it would conduct two 36 month LTROs in December 2012, but the expectation of future inflation seems to be driven mainly by other factors as the effect LTROs disappeared quite fast. One potential reason for a surprisingly stable level of inflation expectations after the 36 month LTROs may be the very nature of liquidity operations. LTROs are simply loans that have to be paid back at maturity, which means that their expansionary effect on credit to businesses and households may be limited if, for example, there is low demand for money.

1,6 % 1,8 % 2,0 % 2,2 % 2,4 % 2,6 % 2,8 % 3,0 %

2005 2006 2007 2008 2009 2010 2011 2012

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Also, it is likely that expected increase in banking regulation and higher capital requirements are simultaneously offsetting some of the expansionary effects on credit.