Member of the Board Tuomas Välimäki
The ECB’s monetary policy implementation and the future operational framework
J.P. Morgan Economic Research Lunch Seminar
London, 26 January 2024
Presentation (pdf)

The ECB’s monetary policy implementation and the future operational framework

Thank you for inviting me to discuss the operational framework of the Eurosystem. This is a topic close to my heart, as I started my central banking career with precisely these issues more than a quarter of a century ago. 

I’d like to start by sharing an anecdote dating back to those days. In the late 1990s, before the Eurosystem, I was part of a task force set up by the European Monetary Institute (the predecessor of the ECB), which had the task of drafting an operational framework for the common monetary policy. We were seated around the table in alphabetical order by country names as written in each national language. As I was from Suomi (Finland), I used to sit between Sverige (Sweden) and the United Kingdom. 

One of the last issues to be resolved in the operational framework was whether or not to have a minimum reserve system in our toolkit. I remember people taking very tough positions on this one, some claiming that this is essential for controlling the creation of money, while others claimed that reserve requirements would amount to a tax that would drive banks out of Europe. Eventually, the compromise solution that everybody could accept was to introduce minimum reserves, but to remunerate them fully in line with market rates.

This solution was not supposed to be a tool for adjusting the monetary policy stance, but was intended to reduce interest rate volatility through the averaging provision that was agreed to be applied to the reserve holdings. Also, minimum reserve system was seen as a mean to enlarge the structural liquidity deficit of the banking system if need be. 

From my point of view, this was a great innovation, and I still believe that the system we adopted was a good one. However, looking back, it is interesting to see that when agreeing on the compromise solution, the strongest camp against introducing the minimum reserve system finally consisted only of two members, both of whom were sitting next to me – Sweden and the UK. It turned out that you had a long-lasting impact on our operational framework, as the market rate neutrality of the minimum reserve system was kept all the way until last year, when we at the Governing Council decided to drop the remuneration of minimum reserves to 0%. 

Topics for today [Slide 2] 

The way in which the ECB should implement monetary policy in the future is particularly topical now, as the Governing Council announced in December 2022 that it would be reviewing its operational framework for steering short-term interest rates. This process should also provide at least a little more clarity on the endpoint of the balance sheet normalisation process. President Lagarde yesterday mentioned that we aim to conclude the review by the end of this spring. Staff at the Bank of Finland are participating actively in the Eurosystem’s work. I should perhaps also point out here the excellent speeches on the topic last year by the ECB’s executive board members Isabel Schnabel (2023) and Philip Lane (2023), which can be found on the ECB website. 

The main goal of the operational framework is to ensure that the ECB’s policy rate decisions are transmitted effectively to short-term money market rates. This may appear on the surface as a technical issue, but it is an important one with wide-ranging implications for the functioning of the money market and the Eurosystem’s footprint in financial markets. 

I appreciate the opportunity today to discuss the issue with you as financial market professionals and practitioners. This dialogue will, I’m sure, provide important insights on market functioning and the interaction between the central bank and financial markets. All such information is greatly valued and will contribute to the design of our future monetary policy implementation framework. 

Economic and financial crises impact monetary policy implementation [Slide 3] 

This chart illustrates the various crises that the euro area has experienced over the past 15 years. As professional market participants, you are familiar with these events. In addition to being a threat to our economic wellbeing and having a significant impact on both the real economy and inflation, these crises have also shaped our views on monetary policy implementation. 

After the Global Financial Crisis (GFC), the practice of implementing monetary policy with scarce reserves regimes and an efficient redistribution of reserves via unsecured interbank markets came to an end and has not been revived since. Moreover, many people believe that with current capital requirements and liquidity regulation, this market segment simply will not come back. Since the GFC, central banks have introduced various unconventional policy measures to tackle different crises. In the euro area, we’ve had to deal with the sovereign debt crisis, significant risks of deflation, the pandemic and then a major war in Europe. During this process and especially after the COVID pandemic, central bank balance sheets across the world grew significantly. 

Now, with the normalisation of monetary policy under way, a natural question arises: what should be the new normal in monetary policy implementation? What is the preferred end point of normalisation? Given all the changes in the economic, financial, regulatory and monetary policy environment, should we return to the ‘old normal’ – or is it even possible? And if not, then what are the options and issues to consider? 

Eurosystem balance sheet has grown significantly [Slide 4] 

Let me now dive deeper into the Eurosystem balance sheet and our operational framework for monetary policy implementation. As I already mentioned, central bank balance sheets globally have reached new highs, and this is certainly the case for the Eurosystem as well. 

Until 2008, our balance sheet stayed always below EUR 2 trillion. But after the GFC, to cope with one crisis after another, we expanded our balance sheet first via large credit operations and subsequently via asset purchases. Finally, in 2022, the exceptionally strong monetary policy easing took our balance sheet to its highest level so far, at almost EUR 9 trillion, which is equivalent to almost 70% of the euro area annual GDP. 

In practice, the Eurosystem has funded its unconventional measures by creating new reserves that banks hold as deposits at national central banks. 

Banking sector shifted from scarce to abundant reserves, turning the deposit facility rate into the policy rate [Slide 5] 

These charts illustrate the changes in monetary policy implementation that were triggered by the increase in reserves. On the left you see excess liquidity in the banking system, i.e. deposits by banks at the central bank exceeding the sum of minimum reserve requirements. On the right, we have the key ECB interest rates as well as key overnight unsecured money market rates. 

In the ‘old normal’ until 2008, the ECB’s control of short-term money market rates was based on the rate at which banks borrowed reserves from the Eurosystem in the weekly main refinancing operations (MRO). But since banks now hold considerably larger excess reserves, the level of short-term money market rates is, in practice, set by the rate at which banks deposit reserves with the Eurosystem. Therefore, the ECB’s most important policy rate has changed from being a lending rate to the deposit rate. 

Especially since the start of large-scale asset purchases, with the asset purchase programme (APP) in 2015, money market rates have experienced very little volatility and have been closely tracking the ECB deposit facility rate (DFR). Of course, the now-discontinued euro overnight interbank market rate (EONIA) was trading above the DFR. In contrast, the current benchmark rate, the €STR, is trading slightly below the DFR, as most transactions taking place are deposits to banks by non-banks that do not have access to the central bank. 

Asset holdings and credit operations on a downward path [Slide 6] 

As you know, due to high inflation the Governing Council has been normalising monetary policy. In addition to raising rates, we have reduced the size of our balance sheet. Banks have repaid the bulk of their long-term central bank refinancing that we provided to them through targeted longer-term refinancing operations (TLTROs). We have also discontinued reinvestments under the APP. At the end of this year, we intend to discontinue reinvestments under the pandemic emergency purchase programme (PEPP) as well. 

This means that our balance sheet – and therefore also the amount of reserves in the banking system – is shrinking. The outstanding credit operations have already dropped below the levels seen before the pandemic and are likely to drop even further this year. Our balance sheet will also be reduced due to securities maturing. Our balance sheet must be run down gradually and predictably to avoid any hiccups in monetary policy transmission. Of course, we also stand ready to counteract any potential tensions if warranted, through flexibility for PEPP reinvestments or by use of the Transmission Protection Instrument (TPI). Credit operations also continue to be allotted with the fixed-rate full allotment (FRFA) procedure, which insures banks against any sudden liquidity hiccups. 

Time to reconsider future control of interest rates [Slide 7] 

At a time when monetary policy is being normalised, it feels like an opportune moment for the ECB to review how it wants to control short-term money market rates in the future. The review is naturally also of interest to financial market participants. For example, bond market participants will want to know how much and which type of assets the Eurosystem is to hold in its balance sheet.

Furthermore, the ECB has a secondary objective of supporting the economic policies of the EU, including the EU’s climate policies. The ECB could decide to act in this regard, without compromising its monetary policy objectives. This could potentially have consequences for environmental, social and governance (ESG)-related assets.

Finally, the rate steering mechanism used by the ECB determines the relative position of different money market rates with respect to the ECB policy rates and has implications for the functioning of the money market in general. Market participants have already been active in providing their views on the future operational framework for the Eurosystem. 

Alternatives for controlling market rates [Slide 8] 

Next, I would like to discuss some important aspects that will affect our decisions about the new operational framework.

We know that interest rates can be controlled in many ways. This is clear just by looking at how central banks in different countries have decided to conduct monetary policy in the post-pandemic era. The Federal Reserve, the Bank of England and Sweden’s Riksbank all have different frameworks for controlling rates. 

The ECB, too, has experience of different frameworks for controlling short-term rates. As I already mentioned, in the pre-GFC era we kept the supply of reserves scarce, and banks had to borrow reserves from our main refinancing operations (MRO). This kept money market rates close to the MRO rate (point A in the chart). Our other policy rates formed the interest rate corridor around the MRO rate and ensured that excessive rate volatility could not occur. 

More recently, we have operated a regime with an abundant supply of reserves. Banks have deposited a large amount of reserves with the Eurosystem each day, and the DFR has been the main anchor for money market rates (point C in the chart). 

Going forward, as we reduce our balance sheet, excess reserves will also contract. At some point, the decrease in excess reserves will start to pull short-term market rates away from the DFR (point B in the chart). In such a situation, volatility may also increase, potentially increasing risk premia in money markets – if the Eurosystem does not respond via monetary policy implementation. There are at least two obvious options for maintaining rate control: to limit volatility by narrowing the interest rate corridor, or to increase again the supply of reserves in the system.

From my perspective, there are several issues to be kept in mind when designing a framework suitable for the current and future environment. First, the new framework should naturally implement the monetary policy stance in an efficient and feasible way and fulfill all the requirements set by the legal framework of the EU. Second, our new framework should function robustly even with very uncertain and volatile demand for reserves, which will be much harder to forecast than in the past. Third, the capacity of the money market to distribute liquidity may not be as high as it was before the GFC, because of new banking regulations, for example. Fourth, the new framework should be robust in the face of rapid changes in the economic or financial environment. And finally, we must consider the special characteristics of our currency area: the euro area is a bank-based economy with financial markets that may occasionally experience fragmentation.

I am confident that we can design a framework that controls short-term interest rates effectively. In my view, the key trade-off is between how tightly we control short-term interest rates and how large our footprint is in financial markets. In this context, I would like to set out my thoughts on how to balance this trade-off while fulfilling all the necessary criteria. 

Eurosystem balance sheet to stay larger than pre-GFC [Slide 9] 

Even though the Eurosystem’s balance sheet is now shrinking, it is more than likely to remain larger than before the crises. Due to the growth in banknotes and other liabilities – the so-called autonomous factors – the size of the Eurosystem’s balance sheet is unlikely to fall even close to the levels seen in the pre-GFC era, when the Eurosystem’s balance sheet total was approximately EUR 1 trillion. 

As a result, the structural liquidity deficit of the banking system will also be larger, and the Eurosystem has to provide more reserves on a structural – or permanent – basis. In my view, it would probably not be wise to meet all the needs for central bank money through short-term credit operations. The larger the level of autonomous factors on our balance sheet in the future, the more likely it is that both outright bond holdings and longer-term credit operations would be used on a more permanent basis to provide structural liquidity to the banking system. 

Large structural liquidity deficit calls for a mix of instruments [Slide 10] 

Such a mix of structural instruments would be useful. With multiple instruments, the ECB could be sure that the large liquidity need is met, and short-term interest rates are under tight control. The mix of instruments would also allow the Eurosystem to respond flexibly to changes in the economic and financial environment. 

Credit operations would distribute liquidity effectively, directly from the central bank, to all banks that require it, even those with limited access to money markets. Simultaneously, banks’ bids for reserves in credit operations would provide information about the level of reserve demand. This would help to calibrate the framework over time such that the Eurosystem’s balance sheet would not be larger than it has to be for effectively implementing monetary policy. 

To separate the monetary policy setting credit operations from structural liquidity provision, different tender procedures could be used. For rate controlling policy operations, I do not see a need to discontinue the use of the fixed-rate full allotment procedure. Actually, one of the main findings in my PhD thesis more than 20 years ago was precisely that fixing the rate in central bank policy operations would be the most efficient way to control short-term rates, especially when banks’ demand for reserves is uncertain. Furthermore, the set of collateral used in these policy operations could be restricted to, for example, high-quality liquid assets (HQLA). However, a wider set of collateral could be accepted in the structural liquidity providing longer-term credit operations. To prevent distortions in bank funding markets and limit regulatory arbitrage, the central bank could act as a rate taker in these operations. That is, a variable-rate tender procedure could be used here to charge a price for the possibility of liquidity transformation. 

A structural outright bond portfolio could be used to provide a stable supply of reserves and maintain a steady presence in the bond market. Without prejudice to the price stability objective, at least some of the structural bond portfolio holdings could be targeted using climate criteria. 

However, the size of the structural bond portfolio should probably be limited, especially if there is a desire to switch away from the current supply-driven floor system. Also, an unnecessarily large outright portfolio would increase the Eurosystem’s impact on the bond market beyond what is normally required to effectively control short-term rates. 

The size of the structural liquidity deficit will evolve over time and the exact calibration of the optimal structural reserve supply will be an empirical question. The same goes for calibration of the relative shares between a structural bond portfolio and structural longer-term credit operations. In any case, I am confident that if we use both tools we would set up a framework that ensures our ability to control money market rates effectively in all circumstances, which is of course always the main goal. 

Controlling rates with short-term operations in a corridor system [Slide 11] 

Structural instruments are designed to fulfill a structural liquidity deficit. But the actual steering of short-term rates should be conducted through a shorter-term credit operation that provides marginal reserves to the banking system. And as I mentioned earlier, maintaining the FRFA procedure in rate steering policy operations might be wise. This would also contribute to financial stability.

Currently, with abundant reserves, the width of the policy rate corridor makes little difference. But once reserves contract, this may not be the case. A relatively narrow interest rate corridor would limit market volatility, as illustrated in the chart (the shift from the pink dotted lines to the black lines). This would also squeeze the reserve demand curve (the shift from the pink dotted curve to the blue curve). Maximal rate control would be achieved if the corridor is very narrow or even zero, i.e. if the borrowing and lending rates are equal. 

But the downside of a narrow corridor is that at least some interbank market activity would be crowded out by the central bank. Applying a narrow pool of eligible collateral for the policy operations could be used to avoid excessive central bank footprint and limit liquidity transformation by banks. The ECB will have to weigh the pros and cons of different corridor widths and modalities of credit provision in its future operational framework. 

If the ECB decides to control short-term rates via short-term credit operations, it is essential that banks would be content to borrow from these operations. Indeed, in a demand-driven reserve regime, there must be no stigma attached to the credit operations. Banks, other market participants and financial regulators alike would need to accept that borrowing from the central bank is business as usual. Otherwise, the central bank’s ability to control money market rates would be greatly reduced. 

On the Bank of England framework [Slide 12] 

As we are here in London, I would like to take a moment, if I may, to look at the Bank of England’s operational framework. 

With its balance sheet also contracting, the BoE has introduced Short-Term Repo (STR) operations, which are short-term loans against high-quality collateral and an FRFA procedure. These operations should be able to respond in a timely manner to any increase in reserve demand. The BoE’s liquidity provision is also supported by longer-term credit operations against a broader collateral set. 

The BoE has chosen a rate corridor with zero width and taken measures to encourage banks’ participation in operations if they need reserves. Hauser (2023) notes that the BoE may decide to explore whether its framework can be calibrated in the future to restore even more market incentives in the rate steering process. 

As I have argued today, the BoE’s framework includes some elements that I think might also be well suited to the Eurosystem. 

Issues for discussion [Slide 13] 

I have laid out some principles that in my view are important for the design of a new operational framework for the ECB. At this point, I would be keen to hear your thoughts on how the ECB should control interest rates in the future, and what you think are important aspects to consider. I have set out some possible topics for discussion on this slide, but feel free to raise other issues as well. 

[Slide 14] Thank you for your attention! I am now happy to take your questions.


List of the links in the text

Back to normal? Balance sheet size and interest rate control. Isabel Schnabel, Member of the Executive Board of the ECB. Published on 27 March 2023. 
Central bank liquidity: a macroeconomic perspective. Philip R. Lane, Member of the Executive Board of the ECB. Published on 9 November 2023. 
‘Less is more’ or ‘Less is a bore’? Re-calibrating the role of central bank reserves. Andrew Hauser, Executive Director for Markets, Bank of England. Published on 3 November 2023.