The European Central Bank needs to review its special programmes that make available cheap money to banks in Europe in order to become more effective in fighting inflation, Banque de France governor François Villeroy de Galhau told central bankers at their meeting in Jackson Hole.
The programmes, known by acronyms such as TLTRO, APP and PEPP, reduce the effectiveness of the eurozone’s monetary policy transmission system while generating additional profits for commercial banks at the expense of the ECB. Villeroy said the programmes offer “a sizable risk-free income to the banking system and a loss for the euro system”.
Speaking at the conference on Saturday, Villeroy raised the issue by asking how central banks should “remunerate massive excess liquidity” in an environment of positive interest rates. He labelled it as an “issue that we practitioners must now confront.”
“This will be a new situation for most of us, and especially for the euro area,” Villeroy told fellow central bankers, adding that excess liquidity. “The return of policy rates to positive territory would this time provide a sizable risk-free income to the banking system, and a similar loss for the Eurosystem.”
Four trillion euro in excess liquidity
For much of the last decade the programmes have made available ECB funding to banks under attractive terms but now have led to some 4 trillion euro in excess liquidity, said Villeroy, who also is a member of the ECB’s policy-making council.
Villeroy said the programmes risk harming the transmission system for the ECB monetary policy. “The effect on banks’ net interest income nevertheless… could also distort the transmission of our monetary policy.”
The “transmission system” that central bankers talk about refers to the mechanisms in the economy and how these respond to changes in central bank rates. Higher rates filter through into economic life by making debt more expensive, reducing demand and thus lowering price pressure. In an effective system, higher rates quickly lead to lower demand, but in an economy where other factors come into play, such as high employment, sharply higher energy prices, or special central bank programmes designed for different circumstances, the transmission mechanism can be less effective, which means it can take longer to bring inflation down.
Programmes offer banks chance to boost profits
In a high-inflation environment with rising interest rates, banks and financial sector companies are generally considered as attractive for investors because it means they can earn more money on the loans and mortgages they sell by raising rates in anticipation of higher funding costs. In today’s eurosystem, banks have an additional opportunity to generate profits through the ECB’s liquidity funding programmes.
The official notes of the ECB’s governing council meeting in July, released last week, show that the liquidity programmes were addressed at the time but not in-depth. One Council member who was not identified noted that the “favourable Eurosystem funding” contained the increase in bank funding costs and that the transmission of higher funding costs was “incomplete in some countries.”
Villeroy’s comments at Jackson Hole suggest the thinking over the availability of cheap ECB money has evolved since the July meeting. He said the discussion over the ECB’s liquidity programmes also needs to consider the profits of banks at the expense of the euro system. Although this could trigger a public debate, Villeroy underlined however that the main objective of the ECB is to maintain price stability.
“The possible losses for central banks and the Eurosystem may draw public attention, but the primary objective of monetary policy is price stability, not central bank profitability; and the more relevant issue in this regard, rather than our profit and loss statement, is the financial solidity of central banks’ balance sheets through their levels of capitalised reserves,” Villeroy said, calling for an assessment “in a swift and pragmatic way.”
Determination
Addressing monetary policy in his Jackson Hole speech, Villeroy called for an “orderly” move towards higher rates and for a “significant” rate hike in September. He said the ECB needs to remain committed to bringing inflation back to 2 percent by 2024. “The more open we are about the path, the more committed we must be about the destination of the journey,” he said.
Two other ECB Council members also spoke at the Jackson Hole conference on Saturday. Isabel Schnabel, member of the executive board, laid out a case for higher interest rates in more detail than Fed chief Jerome Powell, and seemed to indicate that the ECB at its next meeting on 8 September might raise rates by 75 basis points.
Schnabel said the ECB needs to follow the “path of determination”, as opposed to the path of caution. ”Monetary policy responds more forcefully to the current bout of inflation, even at the risk of lower growth and higher unemployment. This is the ‘robust control’ approach to monetary policy that minimises the risks of very bad economic outcomes in the future,” Schnabel said.
Speaking from Jackson Hole on Dutch television Friday, Dutch central bank governor Klaas Knot, well known for his hawkish views, said that he prefers a rate hike of 75 basis points on 8 September and that the ECB should raise rates every six weeks until inflation is brought under control.