TLTROs and the ECB: Main Talking Points:
- What can the ECB do to combat the impact of COVID-19
- How Central Banks try to induce spending in the economy
- How a looser monetary policy affects interest rates and inflation
- How will investor’s perception of the Euro change if TLTROs are issued again
The coronavirus crisis has hit economic sentiment hard, starting with an unprecedented sustained sell-off in financial markets followed by an emergency intra-meeting Fed funds rate cut of 50 basis points. The impact of the virus on the economy is expected to be significant and as yet unquantifiable, leading to a pledge from global Central Banks to provide financial aid.
When looking at the European Central Bank (ECB) their options for additional monetary stimulus are a lot more limited than those of the Fed. Having taken interest rates into negative territory and pumping more than 2.6 trillion euros into the economy in the last 5 years, their hands are pretty tied at a time when investors are demanding more policy support.
Given that cutting interest rates is easier to enact, it will probably be the first line of defence for the ECB in the coming days. But there are doubts about the effectiveness of such stimulus given that rates are already at record lows of -0.5%. This move could even lead to a reversal-rate, when monetary policy is perceived to harm rather than aid the economy, and some believe we are already there.
One way of injecting liquidity into the single-bloc, in an effort to boost growth and price pressures, is via Targeted Longer-Term Refinancing Operations (TLTROs). This new round of cheap financing would keep funds flowing in the economy in hope that the current market meltdown is not exasperated by a sudden shortage in lending.
The ECB – Ready to Prime the Economy Again
Central banks have an unconditional predisposition to provide funding to banks that face a liquidity crisis. A method that has previously been used by the ECB to pump money in to the Eurozone economy is Quantitative Easing. QE involves a central bank buying government securities from the market to reduce interest rates and increase the amount of capital in the economy.
As the European Central Bank ended its four-year long QE programme at the end of 2018 with an expectation to increase rates in the following years, a change in the global economic landscape, led by a generalized slowdown in growth, has made the central bank re-think its monetary and fiscal policy strategies. The recent virus outbreak has just added more pressure to an already struggling financial system.
With growth forecasts revised lower at the beginning of 2019, the latest GDP growth forecast left figures unchanged, as the Eurozone economy is now expected to grow 1.2% in 2020, continuing into 2021. But theses figures may have to be revised downward given the material impact the coronavirus is expected to have on worldwide economic development. Inflation, which is needed to control high levels of debt and has a target of 2%, has been revised downward, and is now forecasted to be 1.3% in 2020, compared to a 1.6% forecast in March 2019.
Due to these growth and inflation revisions, the ECB is now looking at the possibility of a new round of TLTRO financing for European banks, with the aim of stimulating the economy and increasing consumer spending.
What are TLTROs?
The generic definition ofTargeted Longer–Term Refinancing Operations (TLTROs) is the following: they are loan agreements that are aimed at enhancing the function of the monetary policy transmission mechanism by supporting lending to the economy.
Essentially, they are an incentivised long-term loan structure given to banks to increase loan creation. Banks whose lending exceed a specified benchmark will be able to borrow from the ECB at rates between zero and -0.4%. These banks will be expected to keep their net spending above the benchmark, and a breach of this level will mean that they will need to pay back their borrowing in advance.
This means that if banks lend enough, the rate the ECB charges them becomes negative, and as bank loans are the main source of credit in the Eurozone, this will in turn increase private spending in the economy.
Although, TLTROs do not protect banks from insolvency, they aim to stabilize their income stream, as they offer very low interest rates that ensure a stability of loans, that will in turn increase the bank’s liquidity ratio.
The weaker a bank and its subsequent economy are, the more dependant they will become on attractive long-term loans from the ECB. Banks that are borrowing more than they are depositing (mainly banks in Italy, Spain and Greece) are highly dependent on ECB auctions for cash. If monetary stimulus stops, the rate at which banks lend to each other will increase, making borrowing more expensive for the rest of the economy.
The ECB has completed two previous rounds of TLTRO funding; one in June 2014 and a following in June 2016. All these loans are expected to mature by June 2020. A new round of financing would have to come before June this year, as debts with a maturity of under a year are not included in liquidity calculations.
How do TLTROs affect inflation and interest rates?
An increase in the money supply, keeping all other factors equal and assuming that the increase in money supply is greater than the growth in real output, will increase prices as there is more money in the economy for the same amount of goods. This will lead to businesses increasing their prices, causing a rise in inflation. If the expansionary monetary policy also includes reducing interest rates, it will add to the inflationary pressure as saving will have a lower return and borrowing will be cheaper, leading to an increase in aggregate demand.
Inflation will cause domestic goods to be more expensive for foreigners which will make them less competitive and will lead to a reduction in exports. This in turn will lower the demand for the local currency and its value will fall in exchange rates. If the supply of the local currency increases, it will put downward pressure on interest rates, making it relatively less attractive to save in the domestic currency, as the rate of return will be better in other currencies. As the domestic currency becomes a less attractive currency there will be a fall in demand which will subsequently lower its exchange rates against other higher-yielding currencies.
An increase in interest rates is a sign of successful expansionary monetary policy. As borrowing becomes cheaper and savings are discouraged, the increase in consumption will increase the velocity of circulation of money in the economy, which will in turn lead to a general increase in the prices. Target inflation has been set at 2%, from which point increase rates should be adjusted upward to control the increase in prices and avoid hyperinflation.
What will this mean for the Euro?
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As the supply of euros in the market increases, it will increase the downward pressure on interest rates which have been in negative territory since June 2014, making it harder for the ECB to increase interest rates in the near future. A less attractive euro will decrease its value in exchange rates against higher valued currencies.
Unless the ECB has evidence that inflation has reached its target of 2% and growth in the economy has reached a stable level, it will have to keep interest rates low to induce spending and increase inflation to its desired level, before it can consider increasing rates.
Read more on the impact of interest rates on forex.
Liquidity scarce banks, especially Italian banks, will be the hardest hit if the ECB doesn’t offer a new round of funding as existing bonds come to maturity, and this could mean a hard hit for the Euro.
But as the possibility of a new TLTRO financing round is increasing rapidly, and people are aware that market conditions are not going as planned, markets will be surprised if the ECB does not extend its financing agreements. This would increase bank borrowing costs which will be passed on to consumers which would add more fuel to the current economic slowdown conditions that the Eurozone is facing. This would probably take a toll on the Euro as people have come to terms with the fact that the Eurozone is not as stable and recession free as it was expected.
Graph 1: Impact of cheap lending on EUR/USD
As can be seen on the graph, the Euro took a hit as the central bank first announced that it would increase its “cheap lending” to European banks, which started in 2014. This news was received quite badly by the markets. As the Eurozone seemed to have recovered from the 2008 financial crisis, markets did not expect that the European Central Bank would need to lend funds to banks, that could only mean that the economy was not as strong as people believed and the economy needed stimulating. This was only confirmed by the Greek-government debt crisis and was followed by liquidity struggling banks in countries like Italy and Spain.
Once the Quantitative Easing program and bank financing consolidated, the Euro started to gain a little more strength against other major currencies like the dollar, but it has not managed to recover those 2013 highs. As mentioned above, markets are now accustomed to the fact that the ECB needs to help banks with their funding as they struggle with liquidity, so a new round of financing is mostly seen as a positive rather than negative sign for the Eurozone economy.
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