ECB’s Operational Framework Review: Shaping the Future of Eurozone Monetary Policy

The European Central Bank (ECB) is on the verge of announcing the results of its Operational Framework Review, a significant technical evaluation that will shape the rules governing how it provides liquidity to commercial banks in the foreseeable future. This review holds paramount importance as it determines the mechanisms by which the ECB influences short-term money market rates, thereby facilitating the transmission of monetary policy to banks and the broader economy.

The current operational framework, established over a decade ago, aimed to address the aftermath of the eurozone debt crisis and the persistently low inflation environment by flooding the financial system with liquidity. However, this abundance of cash, amounting to a staggering 3.5 trillion euros in excess liquidity, has become unsustainable amidst the current economic landscape characterized by rapid inflation and elevated interest rates.

Currently, the ECB employs various channels to provide liquidity, including quantitative easing (QE) through bond purchases, Targeted Longer-Term Refinancing Operations (TLTROs), and regular tenders. However, the ECB’s excessive provision of liquidity has led to a situation where banks are reliant on the central bank for funding, effectively stifling interbank lending.

In response to these challenges, the ECB is expected to adopt a “demand-driven floor” system, where banks will specify their borrowing requirements instead of being inundated with liquidity from the central bank. This shift aims to reduce the excess liquidity burden on the ECB while incentivizing banks to resume lending to each other, thereby revitalizing the interbank market.

Furthermore, the ECB is likely to adjust interest rates to narrow the gap between the rate paid on bank deposits and the rate banks must pay to borrow funds from the ECB. This adjustment, coupled with the introduction of a “structural portfolio” comprising bonds and longer-term loans, seeks to maintain adequate liquidity in the system without specifying a fixed balance sheet size.

However, the implementation of these changes will be gradual, spanning several years, as bonds purchased during QE will gradually expire, and excess liquidity in the banking sector is not expected to normalize until 2029. Additionally, there is reluctance to sell these bonds to expedite the process due to the potential for significant losses.

Overall, the ECB’s Operational Framework Review represents a critical juncture in shaping the future of monetary policy operations in the eurozone. By recalibrating its liquidity provision mechanisms, the ECB aims to navigate the challenges posed by the current economic environment while ensuring the efficient functioning of the financial system and the transmission of monetary policy.