ECB Policy – Understanding the European Central Bank

Although the ECB has other roles, such as protecting the value of the Euro, the only variable it must consider while setting deciding its interest rate policies is consumer price inflation, since the main task of the central bank is maintaining price stability which is defined as inflation close to, but below two percent. As the governing body of the Eurosystem of Central Banks, the ECB is also responsible for maintaining the stability of the European financial system, although it has no legally stated role as a lender of last resort.

As with the U.S. Federal Reserve, the ECB accomplishes this purpose through regular intervention in the interbank market by conducting open-market operations, termed refinancing operations in ECB terminology. There are two main types of refinancing operations (ROs)at the moment, MRO (main refinancing operation) which is the regular and ordinary type with a term of one week, and the LTRO (long term refinancing operation) which usually has a term of three or six months depending on the liquidity analysis of the ECB. The institution also conducts FTOs (fine-tuning operations) which are short-term interventions aimed at managing sudden and unexpected reserve excess or shortfalls in the interbank market.

Here we’ll take a look at the various tools employed by the Central Bank, some important benchmarks, and the main rates.

HCPI

As we stated, the ECB’s main purpose is maintaining inflation below but close to two percent. To determine the success of its actions, and the need for rate adjustments in response to a divergence from its goals, the ECB uses the HCPI statistics calculated by the Statistical Agencies of the various Eurozone member nations. The HCPI is quite simply the CPI harmonized on the basis of a union-wide standard for calculation. Since Eurozone member nations have different statistical methods for calculating the inflation rate, the raw data from each source is not comparable to another. The HCPI is used to resolve this problem.

Apart from the headline number which provides important information and insight into the inflationary pressures encountered by European consumers, the breakdown of the release provides additional information on the sectoral breakdown of price pressures, enlightening us on how deep the commodity market fluctuations can filter into consumer’s pockets. The HCPI data is released by Eurostat monthly at its website, and is readily available to all kinds of users free of charge.

Money supply Growth

Along with the HCPI, the ECB uses money supply growth statistics to gauge the inflationary potential of the European economy. The changes in money supply including the various kinds of time and savings deposits held at banks, and developments in M1 are carefully scrutinized and discussed at the ECB’s monthly report each month, providing important insight into the Bank’s reasoning, and giving clues on future direction. The ECB attaches a much greater importance to monetary aggregates than the Fed, regarding them as a kind of early warning system on the health of the economy and the resilience of the private sector. While the Federal Reserve discusses this subject in about a paragraph or two in the minutes of its meetings, ECB statements regularly feature discussions of developments in monetary aggregates.

The ECB used to have an explicit four percent money supply growth rate target in its early years, but this is all but abandoned in face of the relatively moderate growth and inflation rates realized in spite of a vigorous 10 percent money supply growth rate in the aftermath of the first recession of this century.

The Tools of the ECB

Now that we have examined two most important variables considered by the ECB in interest rate decisions, let’s examine the tools used by the institution for passing its policy decisions to the market. These are the main refinancing rate, the deposit rate, and the marginal lending rate and their corresponding facilities at the central bank.

Main Refinancing Rate

The marginal lending rate is the equivalent of the American federal funds rate. This number determines the rate at which banks with deposits at the ECB must trade them with each other, and as such, it determines the cost of the cheapest money in the Eurozone. The actors in the wholesale interbank market are banks themselves, and they conduct their short-term operations by lending to, and borrowing from each other in return for interest. Since all money originates from the central bank at the most basic level, the rate imposed by the ECB through open market operations is the lowest and the most important one for the economy.

To maintain this level, the ECB regularly conducts main refinancing operations where it allots capital in an auction where banks offering higher rates receive funds until the total amount offered for auction is exhausted. The ECB determines the amount needed based on its own analysis of conditions in the market, but at times of crisis it may also offer unlimited liquidity in order to defuse tensions in the money markets. As such, since October 2008, the bank is conducting its MROs on a fixed basis where amounts are fully allotted at a fixed interest rate, in response to the economic crisis.

Marginal Lending Rate

The equivalent of the Federal Reserve’s Discount Window, this facility acts as the last resort for firms which are unable to obtain funding at the wholesale market by their own actions alone, for whatever reason. By asking additional funds from the ECB financial firms agree to pay a higher interest rate over what is available in the interbank market, but they also overcome their liquidity problems without facing much higher costs, or insolvency in the worst case.

The marginal rate is usually maintained at 100 points above the main refinancing rate of the ECB, although the ECB can modify the value in response to market fluctuations at will. During the crisis the additional cost of borrowing from the ECB instead of the interbank market was first reduced to 100 from 200, and as of August 2009, it stands at 75 points.

All transactions between the ECB and the Eurozone resident banks are confidential. As a result, some banks choose to use the marginal lending facility of the ECB over their own national institutions due to favorable conditions.

Deposit Rate

The deposit rate is the rate which is paid by the ECB for funds deposited with it overnight by Euro-area banks. Usually this option is not preferred because of the very low interest rate offered (at about 100 points below the main refinancing rate). But in cases where there is too much liquidity around, banks will choose to keep some of it at the ECB in order to receive at least some interest on their free cash.

The deposit rate saw heavy use after the Lehman bankruptcy as banks hoarded cash and choose to deposit it with the ECB because of heightened fears of counterparty risk. As of August 2009, the deposit rate stands at 0.25.

EONIA (Euro Overnight Index Average)

We know that the U.S. Federal Reserve’s interest rate decisions are directed towards the overnight interbank market where banks trade funds with each other and create liquidity. The Fed aims to keep overnight lending rates close to its declared fed funds rate. In the case of the ECB the same role is played by the EONIA, which is the cost of overnight borrowing at the wholesale market. There are many swap agreements tied to this main rate, and it is also the benchmark of the central bank’s success or failure at ensuring stable conditions in the Eurozone financial system, as well as being the reference rate for many kinds of interbank transactions.

The EONIA rate is available to the public with a one day delay at the websites of many public institutions. It is also published on a timely fashion by many news providers such as Reuters, or Bloomberg, but access is often limited to subscribers.

The ECB monitors this rate continuously and very carefully, reacting with various open market operations in case that it strays too far from the main refinancing rate for a protracted period of time.

Euribor

The Euribor is quite simply the Euro libor. It is the rate at which Eurozone banks lend to each other on an unsecured basis. It is also the extension of the EONIA (which is limited to the overnight period), to maturities reaching up to a year.

Just as the USD 3-month Libor is maintained within 10 basis points above the federal funds rate usually, the Euribor rates remain relatively close to the ECB’s main refinancing rate unless there is some kind of liquidity shortage in the markets. The ECB does not react to the Euribor rates at longer maturities very strongly, but if the disruptions are too severe, it may conduct special long term refinancing operations to set the market back in order.

As with all Libor equivalents, the Euribor is a powerful benchmark for all transactions conducted in Euros anywhere in the world.

Eurepo

The Eurepo is the benchmark for secured-lending (that is, lending where parties exchange collateral, or enter a repo transaction) among Eurozone member banks. It usually commands lower interest rates than the Euribor, and is the benchmark of choice in longer term transactions. Although Euribor rates are published over period such as 3-months, 6-months, or even 1-year, there is little unsecured lending going on at such maturities, as banks use these terms mostly for benchmarking purposes for various transactions.

The Eurepo rate is available at many public sources with a one day delay.

Conclusions

What is the use of all this data for forex traders? Although they may appear complicated and irrelevant at first, they are the most direct and clear indicators of any shortage of Euros in the market, and as such, they are much more relevant and reliable than technical tools, or any similar approach. The best way of trading these values, however, is not using the Euro pairs, but rather a carry pair where reaction to financial turmoil and difficulties is much sharper and profitable.

In example, when we see a rising trend in the EONIA, or better yet, in 3-month Euribor, there is a significant possibility that banks will contact clients and cut credit in the short term, as they try to rebalance their liquidity position in response to what is anticipated by the trader on the basis of his observations. Neither the banks nor traders know what will happen in the coming days, but both have to be wary and take the dislocations into account in their calculations. There is a high correlation between tensions in the interbank market, and stock market, bond or currency market turmoil. And that is hardly surprising, given the role of banks as the major intermediary in almost all kinds of financial transactions.

Understanding these various benchmarks will allow traders to read reports and news releases knowledgeably, and will also let them react in a timely fashion to sudden, unexpected events. Upon understanding the contents of this text, you’ll be able to understand why the European Central Bank conducts an LTRO at a time, and may even be able to anticipate it, profiting in the process.

Chris Lee

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