ECB to keep floor under market rates but with eye on demand

Citing four sources, Reuters reported on Thursday, the European Central Bank (ECB) policymakers’ meeting in Frankfurt last week agreed that the ECB would stick to a "floor" system, where the central bank effectively sets the lowest rate at which banks would lend to each other.

Additional takeaways

The ECB will not single-handedly decide how much liquidity it provides to the banking system once it has finished draining excess reserves some years from now.

Policymakers agreed commercial banks would help determine that by borrowing the reserves they need from the ECB.

To facilitate this, the ECB will make it cheaper for banks to borrow by lowering the rate on its weekly cash auctions, currently at 4.5%, and bringing it closer to its 4.0% deposit rate.

Policymakers also agreed they would tolerate some fluctuations in the Euro Short-Term Rate (ESTR), the benchmark in the inter-bank market, around the ECB's own deposit rate.

They expect to announce this new framework -- known in market parlance as a "demand-driven floor" -- next month, potentially as early as the ECB's non-policy meeting on March 13.

Market reaction

The Euro shows little to no reaction to the above report, with EUR/USD flatlining near 1.0835, at the press time.

ECB FAQs

What is the ECB and how does it influence the Euro?

The European Central Bank (ECB) in Frankfurt, Germany, is the reserve bank for the Eurozone. The ECB sets interest rates and manages monetary policy for the region.
The ECB primary mandate is to maintain price stability, which means keeping inflation at around 2%. Its primary tool for achieving this is by raising or lowering interest rates. Relatively high interest rates will usually result in a stronger Euro and vice versa.
The ECB Governing Council makes monetary policy decisions at meetings held eight times a year. Decisions are made by heads of the Eurozone national banks and six permanent members, including the President of the ECB, Christine Lagarde.

What is Quantitative Easing (QE) and how does it affect the Euro?

In extreme situations, the European Central Bank can enact a policy tool called Quantitative Easing. QE is the process by which the ECB prints Euros and uses them to buy assets – usually government or corporate bonds – from banks and other financial institutions. QE usually results in a weaker Euro.
QE is a last resort when simply lowering interest rates is unlikely to achieve the objective of price stability. The ECB used it during the Great Financial Crisis in 2009-11, in 2015 when inflation remained stubbornly low, as well as during the covid pandemic.

What is Quantitative tightening (QT) and how does it affect the Euro?

Quantitative tightening (QT) is the reverse of QE. It is undertaken after QE when an economic recovery is underway and inflation starts rising. Whilst in QE the European Central Bank (ECB) purchases government and corporate bonds from financial institutions to provide them with liquidity, in QT the ECB stops buying more bonds, and stops reinvesting the principal maturing on the bonds it already holds. It is usually positive (or bullish) for the Euro.

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