There are many channels through which changes in the monetary policy stance are transmitted to the real economy. Recent statements by Draghi and Noyer (and a dropped word by Nowotny) suggest that the ECB is concerned about the uneven transmission of its July interest rate cut to bank lending rates across the Euro area. Goldman finds this empirically true noting that the influence of official ECB rates on retail interest rates in Italy and Spain has diminished, while it has increased in Germany and France and in fact there is a ‘reversal of policy transmission’ in Spain and Italy, whereby ECB rate cuts are now associated with an increase, rather than a fall, in retail rates (as the rapid deterioration in peripheral banking systems has more than offset any impact of lower rates). This 'failure' of standard monetary policy to ease conditions has led to the non-standard measures being discussed now. We see three points from this: rate cuts are less likely than the market believes; while SMP is now being priced in, it doesn't specifically address the transmission-mechanism; and just as Draghi hinted at in his last conference, we suspect he will reiterate his reduced collateral standards and increased eligibility to private-sector loans directly (an LTRO 2.5) - which, however, will necessarily encumber bank balance sheets even more (if Zee Germans will even agree to it).
Goldman Sachs: Broken transmission and non-standard ECB policy
Recent statements by ECB President Draghi and Banque de France Governor Noyer suggest that the ECB is concerned about the uneven transmission of its July interest rate cut to bank lending rates across the Euro area. Consistent with this view, this week we demonstrate how sovereign tensions have segmented financial markets in the Euro area, thereby increasing the divergence of bank lending rates across countries, and hindering the uniformity and transmission of monetary policy.
We highlight two main empirical facts. First, during the financial crisis the influence of official ECB rates on retail interest rates in Italy and Spain has diminished, while it has increased in Germany and France. Second, we observe a ‘reversal of policy transmission’ in Spain and Italy, whereby ECB rate cuts are now associated with an increase, rather than a fall, in retail rates. This observed reversal should not be read as implying that monetary policy now has perverse effects on demand in the periphery. Rather, it suggests that the tightening effect of a sharp deterioration in the state of the peripheral banking system and financial markets has more than offset the impact of lower official rates.
As a result of these considerations, we conclude that the ECB’s July rate cut has failed to loosen financing conditions in the periphery, where stimulus is most needed. A blocked interest rate channel of monetary transmission makes it less likely that the ECB will implement further rate cuts. In line with Mr. Draghi’s recent comments (see European Views, July 26), re-establishing transmission through non-standard monetary policy measures to restore market functioning appears a more appropriate line of policy action.
Broken link between official, market and retail interest rates
There are many channels through which changes in the monetary policy stance are transmitted to the real economy. Here we focus on what has traditionally been seen as the main channel: from changes in central bank official interest rates to changes in market rates (in money and sovereign markets), and on to the final (or retail) interest rates that banks charge on loans to their customers.
In normal times—when financial markets are unified and functioning properly—ECB rate decisions exercise close control over banks’ refinancing costs in the money markets throughout the Euro area. And, albeit with lags of varying length, refinancing costs are passed on by banks to their borrowers: in the end, interest rates on loans and mortgages follow the policy rate in a uniform way across countries.
But, in the context of the ongoing crisis, financial markets have become dysfunctional. This has led to an impairment of monetary policy transmission in general, and of the traditional interest rate channel (described above) in particular. Reflecting this, in a recent speech Banque de France Governor Noyer noted that July’s ECB rate cut had been passed through to borrowers unevenly across Euro area countries: sovereign tensions had segmented the money market, leading to different financing conditions in different jurisdictions.
Here we explore how the relationship between policy rates, money market rates and sovereign yields has evolved over the crisis period and the implications this has had for the variation in financing conditions across Euro area countries. Before the crisis, it was widely assumed in the economics literature that the evolution of longer-term market rates (notably government bond yields) did not exert much influence over the way banks set the interest rates they charge to their customers. Rather, monetary policy decisions have generally been considered to be the predominant driver of retail rates. This assumption mostly derived from the stability of sovereign yields themselves and the spreads between them, which introduced little volatility into retail rates. It was also believed that bank funding costs were only modestly affected by sovereign yields. The latter therefore had little impact on retail rates.
We start here from the assumption that the rate-setting behaviour of Euro area banks—and thus the transmission mechanism of monetary policy—has changed with the onset of the financial crisis, possibly in very fundamental ways. There are a number of inter-related potential drivers of this change, among which:
- The banking system itself has become dysfunctional in the peripheral countries.
- The dislocation in government bond markets has affected bank funding costs through several channels, for example:
- Because of the interconnectedness of bank and sovereign balance sheets, developments in sovereign bond markets (widening and volatile spreads, liquidity strains) also affect wholesale refinancing costs (as can be seen from the persistently elevated CDS for European senior financials).
- The dislocation of government bond markets erodes bank capital: for holders of government debt, capital losses are incurred as yields rise. In a context where bank capital requirements have risen under the Basel III standards, this erosion of bank capital constrains credit expansion.
Changes in the behavior of retail interest rates
Up to the crisis, retail bank interest rates moved in lockstep (albeit with a spread, and after a lag) with changes in the ECB policy rates. The financial crisis has altered this picture. We now observe:
- A new—and significant—heterogeneity across bank interest rates across countries. Spanish and Italian retail rates are much higher than French and German ones, as illustrated in Chart 1.
- A decoupling of some retail interest rates from monetary policy rates (see Chart 2). Since the crisis, changes in ECB policy rates—and in particular the most recent sequence of interest rate cuts—have failed to be reflected in retail interest rates in the periphery, notwithstanding the non-standard policy measure implemented to unfreeze money markets and ease bank refinancing costs.1 As a result, while Italian and Spanish households and non-financial corporations are facing sharp increases in the rates they are charged by their banks, their German counterparts have been borrowing at rates that are declining in line with official rates.
- A higher correlation between sovereign spreads and retail interest rates, as sovereign tensions have played an increasing role in shaping bank funding costs by country.
Exploring the ‘official-market-retail’ interest rate link
We now look in greater detail at the interactions of bank lending rates, official rates and sovereign yields. To do this, we have estimated a model relating retail bank interest rates to the level of ECB official rates and national government bond yields, controlling for short-term adjustments due to changes in official rates and sovereign yields.
We examine the evolution of interest rates on loans to the household and corporate sectors across maturities (between 1 and 10 years), and compare two sub-periods: before and after the start of the sovereign crisis, which we take to be May 2010 (the introduction of first Greek program). We confine our analysis to the ‘Big-4’ countries (Germany, France, Spain and Italy).
The results are summarized in Table 1. The long-term impact of market rates on each retail rate are shown in the first four columns (sub-columns (1) correspond to the period 2003-2010, while sub-columns (2) correspond to the crisis). We find that:
- Most importantly, not only the size but also the sign of monetary policy transmission has changed in Spain and Italy. This can be seen intuitively from the divergence between retail interest rates and the ECB rate in Spain, shown in Chart 2. It is confirmed by the signs of the long-term coefficients on ECB rates: these turn negative for longer-term loans in Italy and Spain, even when controlling for the impact of sovereign yields (second column in Table 1). This evidence of a ‘transmission reversal’ should not be read literally. But it does point to structural problems in the banking sector. Over the crisis period, the deterioration in the state of the banking system—which is not captured in our model—had an impact on retail rates that more than offset that of lower official rates. For this reason, the ECB’s July policy decision failed to loosen financing conditions in the places where loosening is most needed.
- The reaction of retail bank rates to national sovereign yields is not unique to the crisis. It existed before the crisis, but was not so obvious because sovereign yields were so stable and spreads so tight (see third and fourth columns of Table 1). (This relationship may help to explain the well-documented sluggishness in the response of retail bank rates to changes in the monetary policy stance.)
- With the crisis, official ECB rates have lost their influence on retail rates in Italy and Spain, while they have gained influence in Germany and France. This can be seen from the fact that most long-run coefficients on official rates ceased to be statistically significant in Spain and Italy during the crisis.3 By contrast, the importance of the ECB policy rate has increased substantially (and has remained significant) in Germany and France.
Borrowers in the periphery feel the pain more quickly than before
Euro area retail bank rates have always proved sticky in the short term. This contrasts with the US experience, where retail interest rates are more generally indexed to market conditions and therefore move quasi-automatically with them (and thus with policy rates). Our analysis here suggests that retail bank rates have overall become less sticky since the onset of the crisis. This can be seen in the estimated adjustment coefficient shown in the last two columns of Table 1 (i.e., the parameter in the cointegration relationship, which captures the speed at which retail rates revert to their long-term equilibrium level over time).
ECB is likely to be more reluctant to use rate cuts
Our results suggest that the way Euro area banks set interest rates on their loans to households and non-financial corporations exacerbates the macroeconomic strains that are afflicting the periphery. Borrowing rates amplify and entrench the divergence of financial conditions across Euro area countries. Since the Euro area economy is still predominantly bank-financed, this retail divergence in financial conditions adds to that seen in wholesale markets, strengthening the centrifugal forces within the Euro area.
If the transmission of standard monetary policy measures were to deteriorate further and add to the forces promoting divergence of macroeconomic performance across Euro area countries, other things equal the ECB would be less likely to implement further interest rate cuts in coming months. Mr Draghi’s comments in London on Thursday 26 July (“within our mandate, the ECB is ready to do whatever it takes to preserve the euro.; and believe me, it will be enough.” cf. European Views, July 26) support our view that further non-standard monetary policy measures may be implemented in the near future, so as to improve the functioning of financial markets and improve monetary policy transmission.
A key open question is whether such measures will focus on attempts to revive the sovereign markets or rather set out to bypass them by offering more direct support to the private sector.
In the past, the former approach has embodied outright purchases of government debt by the ECB through its Securities Markets Program (SMP). But the resurrection of the SMP threatens to break the current internal compromise on the ECB’s decision-making bodies. And its effectiveness is open to question, given market participants’ concerns about subordination in the aftermath of the treatment of ECB holdings in the Greek debt restructuring.
The ECB may therefore look to support private-sector financing more directly, by further easing of collateral eligibility, increased liquidity support to the banking sector and outright purchases of private-sector assets originating in both the bank and corporate sectors.
Source: Goldman Sachs