Speaking before the European parliament, Mario Draghi, the chief of the European Central Bank, discussed the current state of European banking and what steps were likely to be taken in the near future.
The head of the ECB said that excess liquidity levels had to be monitored closely as they dropped toward levels where they could fuel rising market interest rates, also mentioning the possibility of guaranteeing additional lending from the ECB to banks in order to show the central bank’s commitment to keeping rates low.
Draghi’s main concern is to maintain the efficacy of the forward guidance put forth by the bank earlier this year, by which he stated that interest rates would remain at their historic lows of 0.5 percent for an extended period of time. As signs of an economic recovery being to pile up, many believe that the bank will be forced to raise interest rates sooner than expected. In addition, even if they do not, market interest rates could rise anyways, making it harder for businesses to obtain access to capital.
Draghi pointed to so-called LTROs, or long-term funding operations, which were two programs established by the ECB to lend money to European banks. These operations drastically increased the amount of excess liquidity – the amount of money in the system above and beyond what is needed for banks’ ordinary transactions– to around 800 million euros.
Now, estimates of excess liquidity are at around 225 million euros, down from 250 million euros earlier this month, as banks have begun to repay the loans. When levels sink below 200 million euros, some have expressed fears that a threshold will be reached when market interest rates will rise because capital will be in scarcer supply.
What Draghi hinted at before the European Parliament was the creation of another LTRO. This would solve the excess liquidity problem by pushing cash back into the banking system on a short-term basis. It would have several other positive effects as well, including a natural staggering of loan repayments due to the timing of the new LTRO versus the older ones, and the exposition of the bank’s commitment to keeping down market interest rates. As long as money from the LTRO is in the system, it would hurt the ECB to raise interest rates, making them less likely to do so in the near future.
Draghi has had trouble talking down market interest rates simply with rhetoric partially due to the actions of the American Federal Reserve, which was widely expected to begin tapering quantitative easing earlier this month. The surprise decision to keep the program in place certainly leans credence to Draghi’s forward guidance.
“We are ready to use any instrument, including another LTRO if needed, to maintain the short-term money market rates at a level which is warranted by our assessment of inflation in the medium-term,” Draghi declared emphatically. Exactly what the instruments will look like, and when they will be enacted, if at all, is yet to be seen.