Joachim Nagel ©Gaby Gerster

55th Konstanz Seminar: Joachim Nagel on the Eurosystem’s new monetary policy operational framework

In March 2024, the Governing Council of the European Central Bank approved changes to the Eurosystem’s operational framework for implementing monetary policy. How has the Eurosystem’s monetary policy operational framework been changed? What principles will be followed when implementing monetary policy in the future given the gradual decline in excess liquidity within the banking system? And what trade-offs will have to be made in this context? Bundesbank President Joachim Nagel addressed these questions at the 55th Konstanz Seminar on monetary theory and monetary policy.

In his speech, Dr Nagel stressed that the gradual normalisation of the Eurosystem’s balance sheet had been the catalyst for this adjustment. Excess liquidity peaked at more than €4.6 trillion in November 2022. It has since come down by roughly one-third, to about €3.2 trillion today, he said. 

Eurosystem balance sheet normalisation was overdue

According to Dr Nagel, this shrinking of the balance sheet was long overdue and will free up policy space for the future. At the same time, however, it also raises the question of how the Eurosystem will provide liquidity in the future and how it intends to steer short-term money market rates so that they are as closely in line with monetary policy decisions as possible. The Bundesbank President expects that excess liquidity will continue to decline over the coming years as well. By the second half of 2024, we intend to start running off the pandemic emergency purchase programme, he said. 

What is excess liquidity?

Excess liquidity is the term used by the Eurosystem to refer to the deposits that commercial banks hold with Eurosystem central banks that are in excess of the mandatory minimum reserve requirements. The high level of excess liquidity is particularly a result of large-scale monetary policy asset purchases since 2015. It will continue to decline over the coming years as securities under the APP and PEPP asset purchase programmes mature.

In order to ensure that the Eurosystem’s monetary policy operational framework also remains fit for purpose against the backdrop of balance sheet normalisation, the ECB Governing Council has decided to implement changes. First, we will continue to provide liquidity in the weekly main refinancing operations and three-month longer-term refinancing operations, said Dr Nagel, adding that these will still be settled as fixed rate tenders with full allotment. Second, we will reduce the spread between the main refinancing operations rate and the deposit facility rate from fifty to fifteen basis points as of mid-September 2024, he said. This narrower spread is supposed to incentivise bidding in the weekly operations, so that short-term money market rates are likely to evolve in the vicinity of the deposit facility rate.

Agreement on monetary policy principles

Furthermore, the ECB Governing Council has agreed on a set of principles for implementing monetary policy. The main objective of our operational framework is to implement our intended monetary policy stance, Dr Nagel stressed. This is best achieved by aligning short-term money market rates with monetary policy decisions. If short-term interest rates fluctuate too heavily, this might blur the signal about the intended monetary policy stance, he explained. In addition, the design of the operational framework should be in line with the principle of an open market economy with free competition: The open market economy principle favours the efficient allocation of resources, an effective price discovery mechanism and the smooth transmission of monetary policy. 

According to the Bundesbank President, however, these two principles are somewhat at odds with one another: Unfortunately, keeping fluctuations in money market rates at bay and encouraging money market activity do not necessarily go hand in hand. The adjustment of the operational framework was necessary to reflect structural market changes. However, this does not mean that the new operational framework is set in stone. Over the next two years, the ECB Governing Council will closely monitor whether the new operational framework promotes more or less activity on the money market. In addition, the Governing Council will analyse any potential fluctuations in short-term money market rates as well as their impact on the transmission mechanism of monetary policy.