No, the ECB Has Not Hit a Limit

Last December, VoxEU published an article by Aaron Tornell of UCLA and Frank Westermann of University Osnabrueck titled “Eurozone Crisis, Act Two: Has the Bundesbank Reached its Limit?”.  The article claimed that the Bundesbank was selling securities to come up with the money for loans to peripheral central banks. They argued that the Bundesbank was about to run out of securities to sell and then … well, bad things would happen.

I responded with an article pointing out that no such process of security-selling to fund peripheral loans was actually taking place and so Tornell and Westermann were inventing a fake crisis. (Don’t rely on my word. Read the articles yourself and decide, if you’re interested.)  I’m guessing Tornell and Westermann read VoxEu every so often but, as of yet, I haven’t seen any reply defending their article.

Tornell and Westermann have a new VoxEU article today titled “Has the ECB Hit a Limit?”.  In it, they argue that the ECB has “lost its ability to implement anti-inflationary policy.” This is because the traditional tool for controlling inflation is adjustment of the short-term interest rate and, since the introduction of the LTRO, the ECB is no longer doing much short-term lending.

I’m afraid this argument simply doesn’t hold water. For a central bank to control inflation, what matters is that it can influence the marginal cost of funds for financial institutions, who can then pass on changes in their funding costs to firms and households.

Tornell and Westermann appear to believe that the large amount of long-term funding handed out in the LTRO means that the ECB can no longer affect the marginal cost of funds for the banks that have drawn down these loans. In fact, this is not the case. Here‘s the press release announcing the LTROs:

The operations will be conducted as fixed rate tender procedures with full allotment. The rate in these operations will be fixed at the average rate of the main refinancing operations over the life of the respective operation. Interest will be paid when the respective operation matures.

It is possible that Tornell and Westermann think the interest rate on the LTRO loans cannot be changed because the phrase “fixed rate tender” has been used in relation to these operations. However, that just means that the credit was not auctioned off via a bidding process. The terms of the loans were set by the ECB and all banks with sufficient eligible collateral can obtain funding at these terms.

And as the second sentence from the quotation above makes clear, the interest cost associated with these loans will rise as the interest rate on the short-term “main refinancing operation” goes up. So even if the numbers using the MROs remain low in the coming years, the MRO rate is still the marginal cost of central bank borrowing for banks that are using LTRO funds.

The ECB also has other tools at its disposal to control interest rates, such as the interest rate on its deposit facility. If it sets this rate to 5% then why would any bank make a loan to a firm or household at less than this rate?

Tornell and Westermann acknowledge the possible use of this instrument but dismiss it on the grounds that

high enough interest rates on deposits – without a higher lending rate – might generate losses at the ECB, which is a politically sensitive issue

But since standard ECB practice is to move the interest rates on deposits and the MRO rate by the same amount, the costs associated with a higher interest rate on deposits would be matched by the income associated with a corresponding increase in the LTRO rate. So there is no need to worry that an increase in the ECB deposit rate would generate losses for the Eurosystem.

As with the fake Bundesbank-running-out-of-securities crisis, the ECB losing control of inflation leading to a “risk of de-anchoring long-run inflationary expectations” is another thing that people don’t need to worry too much about right now.

Personally, I hope Tornell and Westermann have hit their limit on limit-hitting articles.