Thursday 08 June 2023
The ECB at 25 years - Chronicle of a stormy youth
On 1 June 2023, the European Central Bank (ECB) will be 25 years old. Younger than its peers (the Bank of England was established in 1694), it has nonetheless grown up fast over the years while weathering successive crises.
THE EUROPEAN MONETARY INSTITUTE, FORERUNNER TO THE ECB
The European Monetary Institute (EMI) was founded in January 1994 to supervise the coordinating monetary policies in the run-up to the establishment of the ECB. It was on 1 June 1998 – 25 years ago – that the ECB replaced the EMI. As a token of continuity between the two institutions, the EMI’s president, Wim Duisenberg, became the ECB’s first president. The birth of the ECB was one of the two key stages of constructing the Economic and Monetary Union and happened prior to the advent of the single currency, on 1 January 1999. It closed out a decade of a renewed efforts at European construction.
20 COUNTRIES IN THE EURO ZONE WITH STRONG POPULAR SUPPORT
When it was established, the euro zone had 11 member countries: Germany, Austria, Belgium, Spain, Finland, France, Ireland, Italy, Luxembourg, the Netherlands and Portugal. On 1 January 2023, Croatia became the euro zone’s 20th member-country. To date, no country has left the euro zone. Its approval rate runs very high among the general public, with the latest Eurobarometer survey, conducted in 2023, finding that 79% of respondents were in favour of it and only 16% against. The approval rate rose sharply after the euro zone crisis.
4 PRESIDENTS, 4 VICE-PRESIDENTS BUT STILL NO GERMANS
In its 25-year life, the ECB has had four presidents: Wim Duisenberg, Jean-Claude Trichet, Mario Draghi and Christine Lagarde. Notably, there has never been an ECB president or vice-president from Germany, the euro zone’s largest country and also the country where the ECB is located. Several German members of the Governing Council have not completed their terms due to disagreements with ECB policies, including Jürgen Stark (2011), Sabine Lautenschläger (2019) and Jens Weidmann (2021). Even so, there has always been a German on the Executive Board. France has had one vice-president and two presidents. Each ECB president has had his/her own style, often marked by the economic and financial context. For example, the euro zone crisis and low inflation coincided with the term of Mario Draghi, while Christine Lagarde’s term was marked by the Covid crisis and the return of inflation.
THE EURO ZONE CRISIS: AN EXISTENTIAL CRISIS
The severe recession of 2008-2009 undermined public finances, leading to growing doubts on the sustainability of public debt. As a result, the bond markets began to discriminate more amongst euro zone governments based on their credit quality, whereas credit spreads had been extremely narrow in the euro zone’s first 10 years. During the euro zone crisis, doubts arose on the monetary zone’s viability. The possibility of an exit by some countries, including Greece, was also raised. The ECB played an important role in resolving this crisis, which was macroeconomically costly (with seven consecutive quarters of negative growth!). This role was highlighted by the 2011 announcement of 3-year Long Term Refinancing Operations (LTRO) and Mario Draghi’s famous statement from July 2012: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” The implementation of quantitative easing (QE) a few years later helped stabilise credit spreads at a low levels during the crisis.
THE 2010S: A DECADE OF LOW INFLATION
European treaties stipulate price stability as the Eurosystem’s main objective. Towards the end of his term, Jean-Claude Trichet boasted that inflation had averaged 1.97% during the ECB’s first 12 years (from mid-1998 to mid-2010), which was close to its 2% inflation target. The least that can be said is that ECB did not achieve the same level of success in the following decade. From 2011 to 2020, core inflation averaged 1%. During that period, under Mario Draghi, the ECB rolled out non-conventional monetary policy tools, such as forward guidance, negative rates, QE, and TLTRO.
THE SWITCH TO A REGIME OF ABUNDANT LIQUIDITY
After organising until then a ‘liquidity deficit’ regime, the ECB Governing Council in October 2008 adopted full allotment in meeting commercial banks’ individual refinancing requests for short- and long-term refinancing operations, in response to banks’ reluctance to lend to each other at that time. Beginning with this decision, refinancing operations rose sharply, and the ECB’s way of implementing its monetary policy was never the same again. It was the fact that commercial banks hold large amounts of excess liquidity that made possible the negative rate policy.
THE NEGATIVE RATES EXPERIMENT
On 5 June 2014, the Governing Council moved its deposit rate into negative territory for the first time, at -0.10%. The ECB then lowered it four times, each time by 10 bps, to -0.50%. Negative rates would last more than eight years in all (or about one third of the ECB’s existence) and end in July 2022. This was one of the most powerful negative-rate experiments ever conducted by a central bank, as it was applied to very large quantities of excess liquidities. In 2019, the ECB decided to lessen the cost to commercial banks by exempting a portion of their excess reserves from negative rates.
THE LONGUE SLUMBER OF MONEY-MARKET RATES
0.8% – that’s the ECB’s average deposit rate during its first 25 years. No wonder money-market rates in Europe stayed so long at very low, and even negative, levels. For example, €ster, which replaced EONIA and represented the euro zone’s overnight, non-collateralised interbank rate, remained in a range of -0.59% to -0.56% for the 12 months prior to the ECB’s July 2022 rate hike. However, the surge in inflation in 2022/2023 changed things, sending the deposit rate to 3.25% by the ECB’s 25-year anniversary.
THE LONG ROAD TO QUANTITATIVE EASING
The idea that ECB could pursue a quantitative easing policy in making massive purchases of securities, was not a given, particularly given a certain conservatism of governors from northern Europe. In 2010, the ECB set up an initial Securities Markets Programme (SMP), but it did not really have the expected effects, due to its small size, lack of transparency, and sterilisation of purchases. For example, the Eurosystem made no sovereign bond purchase between February 2012 and March 2015 – a major difference compared with the Fed and BoJ, which adopted very aggressive monetary easing policies during this period. Not until 22 January 2015, after a steep decline in inflation expectations, did the Governing Council announce a massive securities purchase programme.
ONCE LAUNCHED, QUANTITATIVE EASING WAS MASSIVE
To keep up with the ECB’s securities purchases, you had to familiarise yourself with a veritable alphabet soup, including SMP, CBPP1, CBPP2, CBPP3, PSPP, CSPP, ABSPP, PEPP and others. Whereas the SMP, launched under Jean-Claude Trichet, was limited in scope, QE under Mario Draghi (encompassing all of the CBPP3, PSPP, CSPP and ABSPP programmes) was quite extensive, with securities purchases exceeding net issuance by far and squeezing both long-term rates and credit risk premiums. During the Covid pandemic, this time under the presidency of Christine Lagarde, the ECB launched the Pandemic Emergency Purchase Programme (PEPP) in order to head off the collapse of the European economy.
AND NOW, QUANTITATIVE TIGHTENING
Further to the various purchase programmes, the Eurosystem holds about €5000bn in securities. The acquisition of these securities is financed by the creation of central bank money, and a large portion of that central bank money is remunerated at the deposit rate, which is hugely expensive (the deposit rate is currently 3.25%). This was one reason why the ECB has embarked on a quantitative tightening (QT) plan since March 2023. Beginning July 2023, QT will even become total, as the ECB will no longer invest maturing securities.
LONG-TERM REFINANCING OPERATIONS
Prior to the 2008 financial crisis, the ECB did not lend to commercial banks as much as they wanted: the ECB organised refinancing operations of 7 days (Main Refinancing Operations, or MRO) and 3 months (Longer-Term Refinancing Operation, or LTRO) in limited amounts that it determined itself by estimating what commercial banks needed in aggregate to meet their mandatory reserve requirements. Refinancing operations went through three revolutions:
- the switch to full allotment in October 2008;
- the extension to multi-year maturity (with the 8 December 2011 announcement of 3-year LTROs), which helped resolve the euro zone crisis; and
- incentives to banks to loan more to the real economy, with Targeted Longer-Term Refinancing Operations, or TLTRO. TLTRO I was announced in June 2014. TLTRO II and III followed up, with different terms.
A REVOLUTION IN FORWARD GUIDANCE
Right up to the end of his term, Jean-Claude Trichet insisted, regarding the ECB Governing Council, that “We never pre-commit” on future monetary policy decisions. Even after the 2008 financial crisis and the outbreak of the euro zone crisis, the ECB refused to communicate on its forward guidance, whereas the Fed had been doing so since December 2008. But, beginning in summer 2012, Mario Draghi ceased describing ultra-accommodative measures as “temporary”, and one year later the ECB announced that it would keep key rates low for an extended period of time. Under Draghi, forward guidance had begun to play a much larger role in monetary policy than it had originally, with Executive Board members giving far more public speeches and interviews than during the Trichet era and making use of new modes of communication, for example in replying directly to Internet users via Twitter (#askecb operations). The ECB added yet another twist in its communication strategy in July 2014 when it announced that its Governing Council would no longer meet each month but just eight times per year and, even more remarkably, that Governing council would be published beginning in 2015.
BANKING SUPERVISION, A PREROGATIVE ADDED ON THE WAY
The financial crisis of 2008 and then the euro zone crisis shed light on the need to strengthen and better coordinate European banking supervision. The ECB took part in the process of reforming supervision of the financial sector, including contributing to the work of the Basel Committee on Banking Supervision. Effective 2010, the ECB was given a role of macroprudential supervision of the European financial system via the European Systemic Risk Board (ESRB), under which it monitored detect threats to financial stability and issued alerts and recommendations when needed. This role later expanded. Since 2014, the ECB has taken part in banking supervision via the European Single Supervisory Mechanism (SSM), by organising constant supervision of banking establishments. It also helps prepare stress tests. Banking supervision decisions are made by the ECB Supervisory Board, which is independent of the Governing Council. It also plays a role in the resolution process of European banks. Almost two thirds of ECB staff is now assigned to banking supervision.
A WIDENED ROLE AMONG EUROPEAN INSTITUTIONS
One of the most frequent criticisms of the ECB lies in its sole mandate of price stability, without the explicit objectives of support for growth or full employment, as is the case of the US Federal Reserve or the Bank of England. Indeed, the ECB’s main mandate, as defined in Article 127 of the Treaty on the Functioning of the European Union (TFEU), is to maintain price stability. But Article 127 also specifies that the ECB must lend its support to the EU’s general economic policies and it is in this capacity that it may take part in combating climate change. Interactions between the ECB and the European Union’s decision-making bodies have become far closer since the sovereign debt crisis. The ECB contributed to plans to strengthen the Economic and Monetary Union in 2012 and 2015. Since March 20121, the ECB president has taken part in the Eurogroup and may also attend meetings of the Council of the European Union when items falling under its brief are on the agenda. The ECB also sometimes also works with the European Commission on legislative bills that are under its remit. And a Commission member may attend meetings of the ECB Governing Council. The wording of the Treaty on European Union and the Treaty on the Functioning of the European Union has been sufficiently flexible to allow the ECB to adjust its actions in recent years while keeping it within a legal framework. As a result, the many initiatives taken in opposition to its activities have not gone anywhere.
COMBATTING CLIMATE CHANGE
Until 2018, climate change wasn’t much discussed by ECB members. That all changed with a speech by Benoît Coeuré in 2018 entitled “Monetary policy and climate change”. He compared climate shocks to supply-side shocks involving weaker growth and higher inflation, stating that they posed a dilemma to central banks between growth and stabilising inflation. The ECB’s involvement in combating climate change has been much stronger under Christine Lagarde, who has called climate change an “existential threat”. Since its 2021 strategic review, the ECB has taken climate risks explicitly into account in assessing risks to financial stability and developing its monetary policy, whether physical risks or risks of transitioning towards a “low carbon” economy. For example, it has subjected European banks to climate stress tests and begun to integrate climate criteria in managing its corporate bond portfolio.
EUROPEAN STRATEGIC AUTONOMY: A KEY CONCEPT FOR THE ECB
While globalisation was often put forth by Mario Draghi as one of the drivers of low inflation of the 2010s, Christine Lagarde, who took over as president of the ECB just before the Covid crisis, has warned regularly of the implications for the institution of recurring disruptions in supply chains. Here is how she summed it up2: “There are signs that the global economy could increasingly be a source of shocks for Europe rather than a stabilizer against volatility.” . […] Volatility is likely to rise in the future, not fall.” In reaction to these developments, European authorities are now at work strengthening their strategic autonomy, particularly in reshoring certain activities. This shortening of global value chains obviously has serious implications for the ECB3, as that would very likely affect prices.
WHAT’S NEXT? A HIGHER INFLATION TARGET ?
After its 2021 strategic review, the ECB reinterpreted its price stability mandate, saying, “We are targeting an inflation rate of 2% over the medium term”. However, the euro zone has very likely entered into a phase of structurally higher inflation. The energy transition is likely to create surplus inflation, which Isabel Schnabel, an Executive Board member, calls “greenflation”. Inflation may also become structurally higher, due to demographic trends. The population of working age in the euro zone is shrinking by more than 1 million persons annually and that trend will accelerate, exerting pressures on the job market and, hence, on prices. The issue could arise of how high the inflation target should be. Recently, Christine Lagarde said she was open to raising the inflation target (perhaps to 3%?) but while warning that this debate would not be opened until inflation had fallen back to 2%.
A DIGITAL EURO IN THE OFFING?
The ECB launched a plan in the euro zone in July 2021 for a digital euro and began experimenting with various technologies. Christine Lagarde said she expected the digital euro to be launched by 2025. The digital euro the ECB is working on could mean making “central bank” money available to individuals and companies, which until now has been solely for commercial banks: “a digital euro would be complementing cash, not replacing it”. So, it would not be a parallel currency and would be convertible at parity with physical currency. One of the goals of this “digital euro” would be to give everyone a means of payment that would be risk-free and cost-free. A decision on this issue is due in autumn 2023.
1. Article 12 – Title 5 of the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union.
2. Lagarde C., “A new global map: European resilience in a changing world”, speech given on 22 April 2022.
3. Bank of France, 2023, “Strategic autonomy: what are the stakes for central banks?”.
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Juliette Cohen, Senior strategist, and Bastien Drut, Head of Research and Strategy