ECB mulls how to set rates in future

Bloomberg

The European Central Bank is starting to consider whether the financial crisis changed forever the way it controls interest rates.
A decade of pumping cash into the financial system put so much downward pressure on market rates that all policy makers can do is set a floor — the minus 0.4 percent they impose for holding banks’ deposits overnight. Like the US Federal Reserve and Bank of England though, the ECB will need to weigh whether to revert to a system of controlling rates by keeping liquidity tight.
Core to the debate is whether central banks are better off with large balance sheets and far-reaching policy tools, or if they should scale back to avoid crimping money markets. The answers will likely have long-term ramifications for the credibility of monetary policy.
“The size of central-bank balance sheets will never be as it was before the crisis,” said Samy Chaar, chief economist at Lombard Odier in Geneva. “It’s pretty much a reality now.”
ECB staff are already reviewing the monetary-policy framework, according to euro-area officials familiar with the matter, who asked not to be identified because the work is confidential. A spokesman for the central bank declined to comment. Executive Board member Benoit Coeure said in a speech last month that the future framework is an important decision “that will need time and careful deliberations.”
The ECB’s Governing Council starts a two-day meeting in Frankfurt on Wednesday to set policy. The explosion in liquidity from stimulus measures so far means there are now almost 2 trillion euros ($2.3 trillion) of excess reserves in the banking system, compared with effectively none before the crisis. The deposit facility sets a floor for market rates because it’s the safest place for lenders to park those excess funds overnight.
The ECB, Fed and BOE all previously used a corridor system — so-called because the central bank would manage liquidity to keep short-term rates roughly in the middle of a
defined corridor.
The BOE altered its framework in 2009 and now uses the same interest rate for over-night deposits and for its loans to banks.
The Fed switched to a “soggy floor” gradually after 2008. That’s because the large non-bank sector — such as asset managers and government-backed mortgage financing agencies that can’t place money directly with the Fed — pushed market rates lower than the Fed’s rate on excess reserves. Policy makers introduced another technical tool to soak up that liquidity.