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.
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
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
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.
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.
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.
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 ECB
conducts an LTRO at a time, and may even be able to anticipate it,
profiting in the proces.