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Central Banking 101: LTRO killed the EONIA heartbeat

by Migeru Sat Jul 7th, 2012 at 07:51:17 AM EST

Two weeks ago I attended the annual Minsky Summer Seminar at the Levy Institute. There, Scott Fullwiler of Krugman's flashing neon sign fame made a very nice presentation on Central Bank Operations. He was unfortunate enough to have to compete for the audience's attention with the Germany-Greece Euro 2012 quarterfinal, and he bravely disregarded Bob Barbera's advice to just talk for 5 minutes and then take everyone to the bar to watch the game. In the end I think he managed to keep everyone's attention as his presentation was really nice. You can now see the slides online: @stf18

My Prezi on central bank operations from the Minsky conference a few weeks ago http://prezi.com/bv0dpvapapht/m ...
The companion paper, for those interested, is Modern Central Bank Operations - The General Principles (June 1, 2008)
There are sharp differences between the two approaches that nonetheless remain. Among neoclassicals, the literature on central bank operations is not integrated into models of financial asset pricing or into the so-called "new consensus" model of the economy. Though the latter assumes interest-rate targeting, new consensus models are concerned with the strategy of monetary policy, not the tactics or daily operations; though well-established as a research topic for journal publications, monetary policy implementation remains "a side issue" in neoclassical monetary theory graduate textbooks like Walsh (2003) (Bindseil 2004, 1). Further, neoclassicals still do not consider money to be endogenously created in the banking system, as Marc Lavoie repeatedly notes; indeed, as Charles Goodhart has argued in a series of recent papers, there is in fact no private banking system whatsoever in the new consensus model (e.g., Goodhart 2008a).

This is disappointing, naturally, since the evidence published in the recent neoclassical literature on central bank operations has in fact been remarkably consistent with the endogenous money view of central bank operations. The horizontalist view that central banks only target interest rates directly (not reserve or monetary aggregates) and can do so as precisely as desired has been in particular repeatedly supported by this literature. While the relevant literature could fill several volumes, of special note here is the book by Ulrich Bindseil (2004), former Head of the ECB's Liquidity Management Section, which describes in substantial detail the operations of the Fed, ECB, and Bank of England in a manner that very nearly resembles the horizontalist story.

The purpose of this chapter is to describe ten general principles of modern central bank operations. These ten principles are not intended to be exhaustive or comprehensive; neither are the discussions of the individual principles necessarily exhaustive. Rather, these principles represent "what every economist should now be expected to know" given the large quantities of orthodox and heterodox research in this area and the empirical or anecdotal evidence contained in speeches and publications of central bank officials. As noted already, this research generally confirms the earlier points made by Moore (1988) and other authors associated in one way or another with the horizontalist literature

So hopefully (hah!) that settles the debate on endogenous money creation. Anyway, I think the single most important point (here I'll quote from the flashing neon sign blog) is that
a central bank defends the payments system every day, every hour, every minute, at some price.  This is the essence or fundamental truth of central banking, and anyone who fails to grasp it doesn't understand central bank operations
The price here is the rate that the central bank targets. In the US it's the federal funds rate, and in the Eurozone that's probably the overnight interbank rate known as EONIA. And what's being defended is a safe and sound payment and clearing system, which is the lynchpin (though not the be-all and end-all) of financial stability. However, it appears that the ECB has been doing a crap job of targeting EONIA, or at any rate they are lazy. It's also possible that the ECB has been targeting money aggregates, which would be the ECB's own (and worrying) flashing neon sign. Seriously, does this look like the ECB has been targeting a rate?

For an explanation of the various rates in this chart (EONIA, deposit, marginal, etc) I refer you to my earlier post Central Banking 101: the EONIA heartbeat (February 26th, 2011). The present post will be based upon updating the charts from that article with the last 16 months of data: from February 2011 to June 2012. Much has happened in that time and I'll comment on all that below the fold. I encourage you to read the old post at this point.


So, let's look in more detail at what has been happening since the Great Clusterfuck began 5 years ago...

Now, As one can see from the 13-year chart above the fold, the EONIA is usually all over the place, sometimes spiking up, sometimes down. But there was a period of relative stability which I called "the EONIA heartbeat" which lasted about a year from mid-2009 to mid-2010. Here it is:

As explained in my diary of February 2011, these spikes are indications that banks are low on central bank reserves, and on the last day of a maintenance period they borrow frantically from each other to bring the period reserve average to where it needs to be. This chart includes the starting and ending dates of the reserve maintenance periods to make that clear without a doubt. You can even see a longer than usual reserve period around the Christmas vacation of the ECBankers, with a year-end spike in demand for reserves.

Moving on: after May 2010 the EONIA developed tachycardia, as discussed in the previous diary. Back then I was conjecturing that the cause of the tachycardia was a generalised lack of liquidity, exacerbated by the ECB's decision to withdraw liquidity from the system by "sterilizing" its sovereign bond purchases (the infamous SMP programme). So, what do we see in the data?

We see that it's the LTROs that dun it. Not only the tachycardia went away after the first 3-year "open bar" liquidity operation, but also the heartbeat itself disappeared (save for a single year-end spike). Now the EONIA is a tame rate, banks can obviously manage their liquidity without end-of-period scrambles and the ECB could target a rate if it so wished. I would say that this also vindicates the original hypothesis that the bond purchase sterilizations were withdrawing a liquidity that just wasn't there.

Let me go through the argument for that once more. I claimed that sovereign Euro bonds were already (as good as) money, by virtue of being eligible collateral for weekly refinancing operations which the ECB has been conducting at an unlimited tender (i.e., the ECB lends an unlimited amount against eligible collateral). Therefore, the SMP is just an asset swap. No new liquidity is injected into the system by bond purchases. What the ECB does is take credit risk off the balance sheets of the bondholders, but it does so in a liquidity-neutral fashion. When the ECB turns around and offers 1-week deposits at the repo rate "to sterilise the inflationary effects of the extra liquidity injected into the system by the SMP", it is actually attempting to withdraw an extra liquidity that just isn't there. As a result, the EONIA goes into arrest: banks, which (in the aggregate) had just about enough liquidity to meet their reserve requirement (as evidenced by the "heartbeat") now have less liquidity available. And it was the LTRO, flooding the banks with long-term liquidity against eligible collateral, that fixed it.

Display:
So now you know what the 3Y LTRO was good for.



If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Migeru (migeru at eurotrib dot com) on Sat Jul 7th, 2012 at 07:52:31 AM EST
However, it appears that the ECB has been doing a crap job of targeting EONIA, or at any rate they are lazy.

The way EONIA acts is just how you would expect if half the banking system is insolvent. That's not a matter of the ECBuBa failing to target a rate, that's a matter of insolvent banks not being taken out back and shot.

It's also possible that the ECB has been targeting money aggregates, which would be the ECB's own (and worrying) flashing neon sign. Seriously, does this look like the ECB has been targeting a rate?

Yes. You can tell that the ECBuBa is not targeting monetary aggregates, because only half the interbank market is a smoking crater.

This is how targeting monetary aggregates looks:


(source)

Now, As one can see from the 13-year chart above the fold, the EONIA is usually all over the place,

I wouldn't say that. You only have persistent deviation from the policy rate in three periods: The run-up to the introduction of the Euro as a physical currency, the very start of the great clusterfuck, before the unlimited tenders, when the rate collapsed to the support rate during the present depression.

Everything else is one-day spikes on regulatory reporting days, which of course can go in either direction, clear to the hard boundaries set by the penalty and deposit rates. The Heartbeat is precisely the same story, except that now the spikes go only up, because it's sitting on the hard floor. And after everyone has availed themselves of the LTRO, everyone is flush with reserves, so now nobody needs to borrow at the end of the reporting period.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Jul 7th, 2012 at 08:50:10 AM EST
Everything else is one-day spikes on regulatory reporting days, which of course can go in either direction, clear to the hard boundaries set by the penalty and deposit rates.

Yes, but the volatility is excessive. The ECB appears to be very reluctant to narrow the "corridor" between the deposit and marginal rates. They did so briefly (to ±50bp) at the height of the post-Lehman panic, and when they last lowered the repo rate they preferred to lower the deposit rate to zero rather than narrow the corridor to 0.25 - 0.75 - 1.25, for instance.

As to

does this look like the ECB has been targeting a rate?
Yes. You can tell that the ECBuBa is not targeting monetary aggregates
in his paper, Fullwiler writes:
Because the demand for reserve balances is very interest inelastic on a daily basis (where payment needs dominate the demand for reserve balances) or at least by the end of the maintenance period (where reserve requirements dominate), supplying more or fewer reserve balances than banks in the aggregate desire to hold will simply result in the interbank rate falling to the rate banks earn on balances in reserve accounts (if too many balances are supplied) or rising to the penalty rate assessed on overdrafts from the central bank (if too few are otherwise supplied). As such, a reserve balance "target" would be actually a de facto interest rate target at either the rate paid on balances in reserve accounts or the central bank's penalty rate. In practice, a reserve balance operating target would send the interbank rate fluctuating between these two rates, as banks' demand for reserve balances can shift significantly from day-to-day (depending upon the particulars of the national payments settlement system and the reserve requirement regime).

Significant volatility in the overnight rate is not desirable, however. As a member of the Fed's Board of Governors explained,

A significant increase in volatility in the federal funds rate would be of concern because it would affect other overnight rates, raising funding risks for most large banks, securities dealers, and other money market participants. Suppliers of funds to the overnight markets, including many small banks and thrifts, would face greater uncertainty about the returns they would earn and market participants would incur additional costs in managing their funding to limit their exposure to the heightened risk. (Meyer 2000, 4).
Even within neoclassical economic theory, such volatility in the overnight rate would become problematic from a monetary policy perspective "if [it were] transmitted to maturities which are deemed directly relevant for decisions of economic agents (Bindseil 2004, 100-101).
In ordinary times, the ECB appeared to be targeting "above but close to the repo rate", but it wasn't doing a very good job of it since it tolerated huge volatility on end-of-period days, all the way to the limits of the "corridor". In 2009, the ECB flooded the system with reserves when it switched from fixed-tender to fixed-rate-unlimited-tender weekly refinancing, and the interbank rate collapsed to slightly above the deposit rate, and the ECB didn't mind. So either the ECB changed its interest-rate target from 4% to 0.25% over the course of 2009 and decided to leave the refinancing rate at 1% just for laughs, or we have to conclude that the ECB is not, in fact, targeting a rate. The tachycardia period shows the extreme tolerance of the ECB for overnight interest rate volatility, again inconsistent with EONIA targeting.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Sat Jul 7th, 2012 at 09:45:13 AM EST
[ Parent ]
I do think the ECB minds that the interbank rate collapsed to the support rate. It's just that they like their huge bid-ask spread, so they can't narrow the band. Cue a digression about cutesy rules of thumb and the possibly excessive remuneration of European central bankers.

Of course, if they did narrow the band, they would probably want to drop the MRO rate towards where the support rate currently is, because narrowing the band around the current MRO rate would put them above the zero bound.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Jul 7th, 2012 at 10:03:09 AM EST
[ Parent ]
Recall from the conventional commentary on the recent ECB rate change: Draghi May Enter Twilight Zone Where Fed Fears To Tread(Bloomberg - Jun 27, 2012)
The deposit rate traditionally moves in tandem with the benchmark, which policy makers kept at a record low of 1 percent on June 6.
This is because Central Bankers like nice, symmetric "corridors" around their target rate. There is no reason that the corridor could not be narrower than it is. According to Fullwiler
In some cases, operating procedures aimed at improving the central bank's ability to offset autonomous changes to its balance sheet or accommodate bank demand more precisely have been employed to reduce volatility (some examples related to the Bank of Canada are provided in Principle 8). Combined with a narrow "corridor" between the rate paid on reserve balances and the penalty rate, these tactics can be particularly effective in nearly eliminating deviations from the target rate. But while the former are consistent with the central bank's duties of accommodating the demand for reserve balances described in Principle 4, there are even simpler procedures for effectively eliminating volatility that are consistent with the principle that potential volatility is determined by the width of the corridor. For example, Fullwiler (2005), Whitesell (2006), and Lacker (2006) independently propose that the central bank set the target rate equal to the rate paid on reserve balances while leaving a substantial excess of balances circulating.
This seems to be what the ECB is, de facto, doing since 2009.
Draghi said "a few" officials called for a cut, fueling speculation the bank could act next month.

ECB Liquidity

The deposit rate has served as the de facto benchmark, steering overnight market borrowing costs, since the ECB started to provide banks with unlimited liquidity after the collapse of Lehman Brothers Holdings Inc. in 2008.

As we discussed back in February 2011...
That policy removed the need for banks to borrow from each other to meet their reserve requirements, pushing down interest rates. The euro overnight index average, or Eonia, stood at 0.33 percent yesterday.
Therefore,
"If you want to ease monetary policy, you won't get it from cutting the main refinancing rate," said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam. "Reducing it alone wouldn't translate into lower market rates. Slashing the deposit rate makes more sense."
More Fullwiler:
Given the difficulties in money markets beginning in the late summer and fall of 2007, Mosler (2007) and Goodhart (2008b) propose going a step further and set both the penalty rate and the rate paid on reserve balances equal to the target rate, creating a corridor equal to zero, at least (in Goodhart's proposal) for desired balances equal to some (policy-determined) percentage of a bank's retail deposits. In the context of substantial market unrest, Mosler (2007) argued that "when the [central banks] fully understand their own monetary operations . . ., they will offer funds at or just over their target rates and also have a bid for funds at or just under their target."


If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Sat Jul 7th, 2012 at 09:56:03 AM EST
There might be a case for maintaining a non-zero bid-ask spread at the discount window, because running the discount window has a (small but) non-zero cost. So you want people to not use it too cavalierly.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Jul 7th, 2012 at 10:09:17 AM EST
[ Parent ]
Fullwiler:
Many countries without reserve requirements--for example, Canada, Great Britain, Norway, Sweden, New Zealand, and Australia--have kept overnight rate volatility low by paying interest on central bank balances at, say, 0.25 percent below the targeted overnight rate, and charging interest for overnight lending at, say, 0.25 percent above the targeted overnight rate (Sellon and Weiner 1997, Woodford 2001, Lavoie 2005). The overnight rate then settles between the two rates, without moving outside the range or "spread"; in practice some of these central banks have achieved their target rates with substantially more precision than the Fed (Woodford 2001, Lavoie 2005). This is so even as the demand for reserve balances in these countries is a function only of existing settlement technologies and payment flows and thus is very interest inelastic.
RTE: ECB staff suffering from burnout - union (3 July 2012)
More than 76% said they were working longer hours, for which most of them (77.7%) received no extra pay.

Nearly 16% of those polled said their workload was having a "serious effect" on their private life and/or their health.

...

ECB President Mario Draghi has asked the bank's executive board to approve an increase in the workforce in the coming years, but IPSO said it has not been informed on exact numbers and expressed concern it would not be sufficient.

Risk.net: Banque de France outsources collateral management (25 November 2011)
It was announced on Wednesday that the Banque de France has entered into an agreement with Euroclear France, the French central securities depository (CSD), to effectively outsource its collateral management.

This is the first triparty collateral management service for the French market and will collateralise exposures arising from domestic credit operations conducted by the French central bank.

The system means that when the central bank grants credit to the local market the collateral that it takes from the banks will be screened, monitored and valued using Euroclear France's system.



If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Sat Jul 7th, 2012 at 10:19:08 AM EST
[ Parent ]
I wonder whether the people running the French nuclear deterrent and the Luftwaffe's radar operators have the same cavalier attitude to overwork and outsourcing.

Actually, maybe I should stop wondering that if I want to sleep tonight.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Jul 7th, 2012 at 06:47:52 PM EST
[ Parent ]
Dictionary: Eonia - continuing forever or indefinitely; "eternal truths"; "life everlasting"; "hell's perpetual fires"; "the unending bliss of heaven"
by Upstate NY on Sat Jul 7th, 2012 at 01:05:02 PM EST
Looks like the ECB put an end to forever - at least for now.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat Jul 7th, 2012 at 08:46:27 PM EST
[ Parent ]
So, are we to conclude that the LTRO was a good thing? The interbank market is still reportedly dead.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Sun Jul 8th, 2012 at 03:57:22 AM EST
[ Parent ]
No, it was just a play on words. The LTRO was about as close as the ECB has come to doing its job. The problem remains that that is not close enough. It is only a giant bandaid that only temporizes the situation. To solve the problem it is necessary to mark to market ALL the debt and then to insure that a working banking system is reestablished. That would vaporize trillions of Euros, not to mention what might happen in the hundreds of trillions derivative markets.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Jul 8th, 2012 at 09:45:10 AM EST
[ Parent ]
Not unrelated: GERMAN ECONOMISTS CALL ON CITIZENS TO RESIST END OF DEMOCRACY
172 top economists, including Hans Werner Sinn from the Ifo institute, signed an open letter to Angela Merkel warning of a financial disaster if the permanent ESM and fiscal pact goes ahead.

http://www.spiegel.de/international/europe/german-parliament-approves-esm-and-fiscal-pact-a-841816.h tml

The letter notes that the debts of the southern eurozone banks are three times higher than the national souvereign debts and amount to 9 trillion.

 Wall Street, the City of London and a few German investors and banks are the only winners of the decision to use tax money to shore up failed Spanish and Italian and Irish banks, the economists say.

Recall: Eurointelligence as quoted in the Salon:
Pro European economists in Germany launch a public appeal to support Merkel's euro rescue policy

In a direct response to the public appeal by Ifo president Hans-Werner Sinn and 170 other economists for a citizen's revolt against last week's summit results and the plans for banking union, a group of pro European economists is about to launch a public campaign in favour of Angela Merkel's euro rescue policy, Spiegel Online reports. Sinn's appeal "damaged the reputation of German economic science", Peter Bofinger said of he is one the five so called economic wise men. The director of the Institute for Economics, a research organization close to the employer's federation, said the appeal was "irresponsible" because it "did not have anything to do with economic arguments". Meanwhile Bofinger and Gustav Horn, a left wing economist close the German unions prepare a public appeal in response to Sinn and in support of Merkel's euro policy. The chancellor also reacted to Sinn's criticism by saying the summit results increased common control and not common liabilities. Meanwhile, 54% of the Germans feel that the different euro rescue efforts do not make any sense, a poll for Spiegel Online showed.

Mark Schieritz on the intellectual dishonesty of Hans Werner Sinn's appeal

Writing in his blog Herdentrieb, Mark Schieritz makes an obvious but important point about Hans Werner Sinn's appeal to the German people not to support the banking union. The appeal says the bank debt of the five crisis countries was €9tr, too much for the non-crisis countries. Schieritz says that this is the gross debt, not the amounted needed to recapitalise the banks. He cited the most pessimistic estimates for Spanish bank recapitalisation at €100-200bn. He says the argument of the appeal is based on a dishonest and deliberately misleading interpretation of numbers.



If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Sun Jul 8th, 2012 at 09:51:00 AM EST
[ Parent ]
That Sinn is the one that wrote in Project Syndicate that:

The printing presses at the Banque de France and the Banca d'Italia are working overtime to make up for the outflow of money. But this only furthers the exodus, because creating more money prevents interest rates from rising to a point at which capital would find it attractive to stay.

This is the second paragraph at
http://www.project-syndicate.org/commentary/two-models-for-europe

That seems to imply that the Banque de France and the Banca d'Italia were printing euronotes, which I think they can't do under the current rules of the BCE, am I wrong? What could he be meaning else?

res humą m'és alič

by Antoni Jaume on Sun Jul 8th, 2012 at 03:07:25 PM EST
[ Parent ]
He's using the tired metaphor "printing money" for crediting bank reserve account balances.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Sun Jul 8th, 2012 at 05:20:30 PM EST
[ Parent ]
Never heard it. I stil don't understand, how does that lower interest types? (which seems to bother that Sinn guy)

res humą m'és alič
by Antoni Jaume on Sun Jul 8th, 2012 at 05:30:46 PM EST
[ Parent ]
By expanding the money supply (that's what "printing money" is supposed to mean). This would presumably cause inflation (horrors!) and lower interest rates (because of the increased supply of money), both of which are presumably bad for savers.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Sun Jul 8th, 2012 at 05:51:00 PM EST
[ Parent ]
Quantity of Money Theory  wiki

It was Fisher who (following the pioneering work of Simon Newcomb) formulated the quantity theory of money in terms of the "equation of exchange:" Let M be the total stock of money, P the price level, T the amount of transactions carried out using money, and V the velocity of circulation of money, so that

    M V = P T


It was an advance for its time, which was one of the Gold Standard.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Jul 8th, 2012 at 06:25:35 PM EST
[ Parent ]
That seems to imply that the Banque de France and the Banca d'Italia were printing euronotes, which I think they can't do under the current rules of the BCE, am I wrong? What could he be meaning else?

He means that he wants someone who is not the Bundesbank to pay for defending the Bundesbank's currency policy.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Jul 8th, 2012 at 07:13:07 PM EST
[ Parent ]
Sounds pretty good to me. Just tell me first so I can prepare myself. :p

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Mon Jul 9th, 2012 at 04:38:18 AM EST
[ Parent ]


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