How We Know Eurozone Monetary Policy Is Working Again

In 2013, I showed that the ECB’s monetary transmission mechanism had broken down in the crisis-hit periphery countries. ECB rate cuts were not being passed on to rate cuts on new loans to businesses.

Perhaps the strongest sign that the crisis has ended is that this mechanism has now been restored in the periphery countries. In fact, the link between ECB rates and the rates banks charge on new business loans is now, on average, considerably stronger in the periphery than in the core—as can be seen in the main graphic above. (I use the overnight interbank rate as a substitute for the ECB’s policy rate, as it captures both the ECB’s policy rate and the effects of its QE and lending to banks.)

The turning point was the ECB’s June 2014 announcement of a negative deposit rate and cheap long-term loans to banks—known as targeted longer-term refinancing operations, or TLTROs. This is because these new measures have disproportionately benefited periphery banks.

Periphery banks borrow from the ECB, and have been able to lower their funding costs by switching into cheap TLTROs—which have gotten cheaper with the decline in the ECB policy rate. Banks in Italy and Spain account for over 60 percent of TLTRO holdings. Banks in the core countries, in contrast, tend to hold funds at—rather than borrow from—the ECB, and have been disproportionately hit by the negative deposit rate. As of June, German banks have €551 billion parked with the central bank, just 4 percent shy of the record set in May. In the first half of 2017 alone, they paid, rather than received, €900 million in interest charges—just marginally below the €1 billion they paid for all of 2016.

The ECB’s asset purchase program (APP)—which began in late 2014, and was expanded to include sovereign bonds in 2015—has also disproportionately benefited periphery banks, which made capital gains on their security holdings. Core banks, on average, did not.

With lower funding costs from TLTROs, and higher profits from APP, periphery banks have lowered lending rates to business customers considerably more than core banks have, as the small inset graph shows.

The health of eurozone banks broadly remains poor. But the fact that ECB policy is once again affecting lending rates across the marks an essential step on the path to a sustained recovery.