The TLTRO Failure Will Be A Success

by Filipe R. Costa

The ECB has lent out almost 130 billion euros, under the umbrella of its LTRO program – but now refurbished with a T in front to better express its surgical aim. However, while being relatively new, the Targeted Longer Term Refinancing Operation (TLTRO) is just a new way of expressing the old concern – the economy must be reflated at all costs. The programme will eventually fail and consequently it will be a success!

With its Main Refinancing Operations (MRO) rate currently held at 0.05% and the deposits facility rate now turned into a tax, the ECB needs to make use of alternative measures to drive the real interest rate lower. When the nominal rate is no longer available, the central bank needs to expand its balance sheet using alternative measures in order to revive inflation expectations. For such a goal – and provided that US-style quantitative easing remains outside the bounds of the ECB’s financial arsenal – the TLTRO and the purchase of private securities will do the trick for now.

But, while Draghi has always shown enthusiasm when announcing these measures, investors and economists are not convinced.

The Eurozone is not growing and the risk of deflation is rising every day, as fiscal cuts have been contributing to a major contraction in the euro bloc. At the same time, with oil down by almost 40% YTD, energy costs will negatively impact inflation, further contributing to the deflation scenario. Will the adopted measures be able to neutralise these effects? Not likely!

When interest rates are near zero, there is not much a central bank can do in terms of its regular open market operations. These usually target the short-term interest rates like the EONIA or SONIA and are very effective in doing so when interest rates are relatively high. But when interest rates are as low as they are now, the central bank may need to use unconventional measures to increase inflation expectations so that it can force a decline in the real interest rate and generate investment.

During the Great Depression for example, there was deflation in the US. Even though nominal interest rates were near zero, real interest rates were rising as a consequence of deflation, which contributed to a further contraction in investment and output. The story for Japan is not much different. The main idea is that monetary policy may still be contractionary in the presence of zero nominal rates, as long as the real interest rate is rising. This is the main line of reasoning behind the use of unconventional measures, for which Ben Bernanke is a zealous advocate.

While the above makes sense, or at least, reasonably justifies the central bank’s actions, one should examine further the exact problem faced by the ECB.

Despite its prior actions, the ECB couldn’t prevent a scenario of very low inflation and it is desperately trying to reflate the economy. But unlike his counterpart at the Fed, Mario Draghi’s actions are limited by a rigid ECB mandate which doesn’t allow for large-scale sovereign debt purchases. His best option is therefore to entertain the markets with some temporary programmes until he gathers political backing for QE-style purchases.

When I say entertain I really mean it! Let me explain why…

At a time the traditional lending channel is losing influence (bank loans); at a time banks can get as much funds as they want and when they want; at a time financial innovation allows for alternative ways of financing lending; at a time the shadow banking system is growing; it is not reasonable to think that banks will pick up funds when the ECB wants them to do so, but rather they will demand funds when they want/need them.

If banks were facing demand for loans from consumers and investors, they could use the full-allotment auctions from the ECB to get as much funding as they needed, or they could use the lending facility. There’s no need to wait for the TLTRO.

A glass of water is worth something for you when you’re thirsty. A second glass of water is still worth something, but eventually less than the first one. A third may do more harm than good and be worth nothing. The same applies to loanable funds. If there’s no demand from clients, banks don’t want these funds. If the banks pick up these funds but are unable to loan them, they may have to park them at the central bank at a cost of 0.2% per year.

What drives the demand for funds is the demand for credit from customers. But this final demand has been sluggish in the Euro zone. Loans to non-financial corporations and households have been decreasing over the last few years, no matter how low the costs to borrow. Why would businesses invest if they have excess capacity? How confident is a consumer when the unemployment rate is above 10% on average and above 15% in many countries?

The TLTRO is built on a wrong causality assumption and is condemned to fail as a reflation tool. Of course, banks can do a different thing with the funds they get from the ECB. They can buy sovereigns from peripheral countries such that they can earn some extra yield. Even if they can’t do that with this TLTRO programme, they can do it with the funds they get from the main refinancing operations and eventually leave the TLTRO to refinance existing loans. But such behaviour would just contribute to the creation of a massive bubble in sovereigns without helping much on credit and investment.

In a certain way we are very fortunate that banks are not picking up all the funds the ECB is offering them.

If they did, we could face hyperinflation. But as long as funds are available but parked, there is no reason to fear inflation. By the same token, we also avoid some longer-term problems that could arise with such large-scale credit. Without the central bank we would be fine, as investment expenditures would have to be financed by savings. In such a case, a richer consumer is just willing to put aside a fraction of his present consumption in order to increase his future consumption. In the future, consumption would grow and investments pay off. But when investment is the result of printed money without corresponding savings we are condemned to recession in the future, as the increased supply will not be absorbed by a corresponding increase in demand and most projects will be liquidated. When interest rates are near zero, almost every project is feasible. When rates start increasing again, most of them will become unfeasible.

In summary, the TLTRO package approved in June by the ECB is worth almost nothing and is condemned to fail, as banks don’t need the funds. 

Everyone seems to be ignoring the fact that there is already an excess of liquidity in the system. Banks took 87 billion euros from the available 400 billion and will eventually take another small fraction (unless they use the funds to refinance themselves). For the purpose of increasing its balance sheet from 2 trillion euros to 3 trillion euros, the ECB still has a long way to go. But a persuasive Draghi may very well turn the TLTRO failure into a personal victory, as it will help his case in favour of US-style large-scale purchases which Germany has been opposing. With inflation at 0.4%, oil prices near $60 and the TLTRO falling short of the ECB’s hopes, Draghi has a strong case for future QE.