Why new monetary policy measures?
From a monetary policy perspective, the euro area economy faces two problems, being the prolonged very low inflation outlook and weak lending, in particular to businesses. In order to address these issues, the ECB on 5 June decided to ease its monetary policy stance with a package of additional measures. The primary aim of the ECB’s monetary policy – price stability - is defined as inflation of below, but close to 2% per year over the medium term for the euro area as a whole. In the past year projections for inflation over the medium term were revised downwards several times. The June projections again showed a lower outlook for inflation. The ECB now expects that the inflation rate will remain below target for an extended period of time. Inflation will only very gradually rise to 1.5% at the end of 2016. That is why the ECB has decided to lower its key policy rates further (see DNBulletin) in combination with other monetary policy easing measures (see ECB press release for details). An important component of these measures is a series of targeted longer-term refinancing operations (TLTROs). This non-standard monetary policy measure is designed to stimulate banks to increase lending to the corporate sector and to consumers, thus strengthening the economic recovery.
Weak bank lending
Since the summer of 2012, financial conditions in the euro area have greatly improved, partly due to the ECB's policy. Interest rates on money and capital markets have substantially decreased. To a lesser extent this also applies to interest rates on bank loans. Nevertheless, bank lending is still weak. Annualised growth of lending to the non-financial private sector in the euro area in April contracted by 2.7%, while consumer credit to households decreased 2.1%. This is attributable to both weaker demand for credit, as households and companies are trying to reduce their debt levels, and tighter bank lending conditions. Banks are strict in their assessment of new loan applications, given the risks they observe in the financing of companies and the necessity to maintain sufficient capital buffers. In addition, banks in the euro area are being faced with losses and bad loans resulting from the crisis, which limits room on the balance sheet to extend new loans.
Targeted liquidity support focuses on lending, in particular to businesses
Targeted central bank funding may help prevent limited availability of bank loans from slowing down economic recovery. This especially holds true for the euro area, where businesses largely depend on bank loans for their external financing. TLTROs offer banks temporary access to cheap and longer-term central bank funding. For the loans, the ECB charges a fixed rate equal to the key policy rate (currently 15 basis points) prevailing at the drawdown date of the loan, plus a surcharge of 10 basis points. This is expected to contribute to a further decrease of the financing costs of banks and may lead to lower interest rates on loans in the euro area. Contrary to earlier liquidity measures taken by the ECB, these measures incentivise banks more strongly to extend their loans to the real economy, as the size of the – cheap - funding depends on outstanding and new bank loans to companies and consumers. Loans to households for house purchase are excluded from this measure in order to avoid financial imbalances on the housing market. Banks may increase lending but can also use the funding for purchases of other assets, such as corporate bonds, commercial paper and government paper, which will help bring down rates across the board. However, this can only be done to a limited extent as banks are obliged to repay the loans obtained if they do not keep lending to companies and households above an ECB-determined benchmark.
The ECB is doing everything within its power to secure the availability of bank loans, using these targeted and cheap liquidity support measures, and the asset quality reviews and stress tests of banks that are currently being conducted. Whether or not credit growth will indeed pick up also depends on developments in the demand for credit and on factors outside the ECB's immediate control.
Negative side-effects of the monetary policy accommodation
The accommodative monetary policy may have unwanted side effects. For instance, the prolonged low interest rate and the sizeable non-standard liquidity support necessary to kick-start the economy and inflation may unintentionally reduce the incentive for governments and private institutions to make structural adjustments and reforms. The low interest rates dampen the debt burden on the budget, which may trigger governments to postpone measures to restore sound public finances. Accommodative monetary policy could also induce excessive risk-seeking behaviour with investors in their search for better returns. This may give rise to undesirable build-up of bubbles in some market segments.
In view of the risks and unintentional side-effects, the new liquidity support to banks is temporary and targeted to address bottlenecks in lending. For sustainable economic recovery in the longer term, it is crucial that other policymakers and institutions do not relent in their reform efforts. Banks should also unabatedly continue their balance sheet restructuring effort, which has been given an additional impetus with the arrival of the banking union. Ultimately, banks will have to be able to obtain their funding in the market at favourable conditions, independent from the ECB.
Given the outlook for inflation in the short-term, accommodative monetary policy is required. That is why the ECB has indicated that the key policy rates will remain at present low levels for an extended period of time. Moreover, if the inflationary outlook continues to deteriorate, the ECB may act by taking further monetary policy measures.