Analyses focus on current issues of particular relevance to Danmarks Nationalbank’s objectives. The analyses may also contain Danmarks Nationalbank’s recommendations. They include our projections for the Danish economy and our assessment of financial stability. Analyses are targeted at people with a broad interest in economic and financial matters.
The ECB’s new monetary policy framework has no impact on the implementation of the fixed exchange rate policy
On 13 March 2024, the European Central Bank (ECB) announced adjustments to its operational framework for implementing monetary policy. The ECB has made these adjustments to ensure the effective pass-through of monetary policy interest rates as the Eurosystem balance sheet normalises. Going forward, the ECB will continue to steer short-term interest rates in the euro area money market through its deposit facility rate, but will tolerate some degree of volatility. The ECB’s new operational framework does not create a need to adapt how Danmarks Nationalbank implements the fixed krone exchange rate policy in Denmark.
Key messages
Why is it important?
Danmarks Nationalbank has a fixed exchange rate policy. This means that the Danish krone exchange rate is kept stable against the euro. The exchange rate is influenced primarily by the differential between money market interest rates in Denmark and the euro area. This is because the money market spread determines how attractive it is to buy kroner vis-a-vis the euro and the cost of hedging between the two currencies. The ECB steers money market interest rates in the euro area through its operational framework for implementing monetary policy. In March 2024, the ECB announced changes to its operational framework, which may have an impact on money market interest rates in the euro area and could also indirectly affect the market for Danish krone going forward.
Main chart
The corridor between the ECB’s monetary policy interest rates will be narrowed
Note:
The grey bars indicate the spread between the ECB’s monetary policy interest rates. For the period prior to the financial crisis, the spread is shown for all three monetary policy rates, and subsequently for the spread between the ECB deposit facility rate (DFR) and the weekly main refinancing operations (MRO) rate. APP refers to the ECB’s Asset Purchase Programme, which was introduced in January 2015. The first interest rate rise as part of the current tightening of monetary policy was made on 21 July 2022. OFR is short for Operational Framework Review.
Source:
ECB, Refinitiv Eikon, Bloomberg and Danmarks Nationalbank.
The ECB’s new operational framework and background to the adjustments
This chapter explains the new operational framework of the European Central Bank (ECB) and the background to the adjustments. Chapter 2 explores why the ECB’s new operational framework does not create a need to change how Danmarks Nationalbank implements the fixed krone exchange rate policy in Denmark.
The normalisation of the Eurosystem balance sheet has created the need for a new operational framework for the implementation of monetary policy
On 13 March 2024, the ECB announced a new operational framework for the implementation of monetary policy in the euro area. This followed a review that was announced in December 2022.1 The aim of the review was to ensure that the ECB’s monetary policy continues to be transmitted effectively to financial markets as it gradually normalises the Eurosystem’s balance sheet and excess liquidity therefore declines.2, 3 Excess liquidity refers to the total bank deposits in the Eurosystem after commercial banks have met specific requirements to hold a minimum level of reserves. The ECB can provide liquidity to the banking system by increasing its balance sheet, for example, through monetary policy lending or through asset purchase programmes.
The ECB’s Governing Council will continue to steer the monetary policy stance through the deposit facility rate (DFR), which has been the case periodically since 2008 and de facto since 2015. In order for the DFR to remain the anchor for euro short-term money market interest rates, there needs to be a sufficient amount of excess liquidity in the banking system. Therefore, once the normalisation of the ECB’s balance sheet is more advanced, the ECB intend to provide liquidity to the banking system through a new structural portfolio of securities and longer-term refinancing operations.4 Banks will still be able to borrow as much as they need from the ECB on a weekly basis, against eligible collateral. However, from 18 September 2024, the spread between the interest rate on weekly lending operations and the DFR will be reduced from 50 to 15 basis points. The reduction in spread is intended to limit volatility in short-term money market interest rates as excess liquidity declines.
The amount of excess liquidity in the banking system determines which of the monetary policy interest rates is the anchor
The ECB offers deposits and loans to monetary policy counterparties at different interest rates. Counterparties’ deposits earn interest at the DFR. The interest rate on lending to counterparties depends on whether it is via weekly main refinancing operations (MRO) or daily lending via the ECB’s marginal lending facility (MLF).
The amount of excess liquidity in the banking system determines which of the three monetary policy interest rates is the anchor for short-term money market interest rates. In the euro area, the euro short-term rate (€STR) is the benchmark overnight money market interest rate and is calculated by the ECB using overnight deposit transactions in the money market. The €STR accounts for only a small proportion of transactions in the European money market, while loans collateralised by securities (repurchase agreements) account for the majority of daily transactions.5 However, developments in the €STR are reflective of the effectiveness of transmission of the desired monetary policy stance to broader financial markets and the real economy. It is therefore essential for the ECB to be able to steer the €STR using its monetary policy interest rates.
High excess liquidity, and hence a large amount of deposits with the ECB, curbs commercial banks’ incentive to borrow in the money market at a higher interest rate than the ECB’s DFR, which thus becomes the anchor, see point A in chart 1. Conversely, low excess liquidity may mean that some banks lack liquidity, causing money market interest rates to rise towards the ECB lending rates, the MRO and MLF, see point B in chart 1. Since the financial crisis, and especially since 2015, excess liquidity for banks in the Eurosystem has increased significantly. This is due to the ECB’s long-term lending facilities and asset purchase programmes, including the ECB’s Asset Purchase Programme (APP) from January 2015 and later the pandemic-related purchase programme (PEPP) from March 2020. The ECB’s DFR has therefore been the anchor for euro area money market interest rates over this time (a so-called ‘floor system’), see chart 2.
Chart 1
Excess liquidity in the banking system determines which monetary policy interest rate is the anchor
Note:
MLF indicates the interest rate on the ECB’s daily marginal lending facility, MRO indicates the interest rate on the ECB’s weekly main refinancing operations and DFR indicates the interest rate on the ECB’s deposit facility.
Source:
Danmarks Nationalbank.
Chart 2
The ECB deposit facility rate has been the anchor for short-term money market interest rates since 2015
Note:
The grey bars indicate the spread between the ECB’s monetary policy interest rates. For the period prior to the financial crisis, the spread is shown for all three monetary policy rates, and subsequently for the spread between the ECB deposit facility rate (DFR) and the weekly main refinancing operations rate (MRO). APP is the ECB’s Asset Purchase Programme, which was introduced in January 2015. The first interest rate rise as part of the current tightening of monetary policy was made on 21 July 2022. OFR is short for Operational Framework Review.
Source:
Danmarks Nationalbank.
Since 2022, the ECB has tightened monetary policy significantly to combat the rise in inflation following the covid-19 pandemic. As the ECB’s longer-term loans to banks have been repaid and asset holdings have gradually matured without being reinvested, the excess liquidity for banks in the Eurosystem has fallen. Despite the decline, excess liquidity remains significant in a historical context, and the ECB DFR has remained the anchor for money market interest rates in the euro area. Going forward, excess liquidity is expected to gradually decline further as the Eurosystem balance sheet continues to normalise, see chart 3. However, it is unclear what level of excess liquidity is sufficient to ensure that the €STR continues to be steered towards the ECB’s DFR (point A in chart 1). This is explored in more detail in the final section of this chapter.
Chart 3
The Eurosystem balance sheet has declined significantly since 2022, and the decline is expected to continue over the next few years
Note:
Sample of Eurosystem assets on the balance sheet. Grey shading indicates the ECB’s main refinancing operations (MROs) and longer-term refinancing operations (LTROs). Turquoise shading indicates the ECB’s targeted longer-term refinancing operations (TLTROs). Red shading indicates the ECB’s monetary policy portfolio, including asset purchases. Expectations are based on the ECB Survey of Monetary Analysts from April 2024.
Source:
ECB and Danmarks Nationalbank.
In order for the deposit facility rate to remain the anchor for short term money market rates, the ECB will ensure sufficient liquidity is provided through refinancing operations and a structural bond portfolio
The ECB will continue to offer liquidity to European banks via weekly MROs, where they can borrow unlimited amounts to cover their liquidity needs provided they post enough eligible assets as collateral. In the longer term, and as existing bond portfolios are reduced, the ECB will provide liquidity via a new structural bond portfolio and longer-term lending facilities.6 The longer-term measures will ensure a structural level of excess liquidity in the Eurosystem, while the MROs (and overnight marginal lending facility) will ensure that banks are always able to obtain sufficient liquidity on a day-to-day basis, or if the need arises suddenly. The ECB has not yet published details of the structural liquidity providing measures, including the scope, composition of the bond portfolio or when they will be introduced.
The ECB will tolerate a certain degree of volatility in short-term money market rates as long as it does not make monetary policy tighter or looser than intended
The determination of the spread between the ECB’s deposit and lending rates is a balancing act between several considerations. On the one hand, a higher spread will support money market activity and ensure that banks are incentivised to seek market-based financing. On the other hand, a higher spread will increase the range for money market interest rates, thereby increasing the scope for higher volatility. The new spread of 15 basis points between the ECB’s DFR and the lending rate on weekly MROs is low in a historical context, see chart 2. By way of comparison, the spread during the financial crisis was 100 basis points. The narrower spread has been chosen to limit how much short-term money market interest rates in the euro area can rise away from the DFR during periods of liquidity shortages. Although the expected reduction in excess liquidity may mean greater fluctuations in the €STR, the ECB has announced that it will only tolerate a certain degree of volatility, and only provided that it does not unduly affect the monetary policy stance.
The level of Eurosystem excess liquidity that may cause euro area money market interest rates to rise is uncertain
An unexpected rise in money market interest rates, purely because of a shortage of Eurosystem liquidity, will affect the transmission of the ECB’s desired monetary policy stance. Since the €STR was introduced in 2019, excess liquidity in the euro area has been large and €STR has therefore been close to the ECB’s DFR. Under the previous reference rate, Eonia, excess liquidity was at times more scarce, which resulted in Eonia being significantly above the DFR, see chart 4.
Chart 4
Historical correlation between overnight interest rates in the money market and excess liquidity in the Eurosystem
Note:
The y-axis shows the difference between Eonia, €STR and ECB’s DFR. The spread is normalised with the spread between the ECB’s MRO rate and DFR. The x-axis shows the excess liquidity in the Eurosystem, which indicates the difference between the liquidity provided to the banking system and the banks’ requirements in terms of reserves.
Source:
ECB, Bloomberg and own calculations.
The historical correlation between excess liquidity and Eonia is likely not a perfect guide to the future relationship between excess liquidity and €STR
This is as there is uncertainty about how much central bank liquidity the banking sector will demand compared to the past. This uncertainty is due to several factors. Increased regulation of the banking sector, including the liquidity coverage ratio (LCR), for example, may have increased banks’ demand for central bank reserves, which have the highest LCR classification.7 Furthermore, banks may wish to hold larger liquidity buffers in case there are periods of increased uncertainty in financial markets that could limit access to market-based financing. Finally, the distribution of excess liquidity between banks may look different to in the past, as the ECB’s asset purchase programmes have led to a significant concentration of excess liquidity in larger banks.8 This means that the ECB is uncertain how much excess liquidity is sufficient for the DFR to anchor money market interest rates in the euro area. The purpose of the new structural bond portfolio and longer-term lending operations is to ensure sufficient liquidity in the longer-term. The weekly MROs are intended to ensure that acute liquidity needs can always be met and do not lead to sudden increases in the €STR that could unduly affect the transmission of the monetary policy stance.
Danmarks Nationalbank’s monetary policy instruments are robust to the ECB’s adjusted operational framework
Due to its fixed krone exchange rate policy against the euro, Danmarks Nationalbank’s monetary policy interest rates largely follow those of the ECB. However, unlike the ECB, Danmarks Nationalbank has not used asset purchase programmes or provided longer-term lending facilities, which the ECB has done extensively since 2015. As a result, the development of Danmarks Nationalbank’s balance sheet, and thus also liquidity in the Danish banking system, has been significantly different than in the euro area since 2015.9 For this reason, Danmarks Nationalbank’s has no plans to normalise its balance sheet in the same way as the ECB intends to.
Danish money market interest rates also depend on monetary policy interest rates and the level of liquidity in the banking system, as in the euro area
Danish money market interest rates depend on Danmarks Nationalbank’s monetary policy interest rates, which are set solely to maintain the fixed krone exchange rate policy. Since 2021, Danmarks Nationalbank has had one deposit and one weekly lending rate with a relatively narrow spread of 15 basis points, see chart 5.10, 11 The spread of 15 basis points was chosen to balance a number of factors, but primarily to ensure stable pass-through from monetary policy interest rates to money market interest rates, which is essential for managing the krone exchange rate against the euro. The spread also allows money market interest rates to move within the corridor when Danmarks Nationalbank intervenes in the foreign exchange market, helping to stabilise the krone exchange rate. For example, if the krone is unduly strong against the euro, Danmarks Nationalbank will intervene to buy euros, providing krone liquidity to monetary policy counterparties. This will encourage lower money market interest rates (see the next section), which will also tend to weaken the krone. Finally, the spread also incentivises banks to exchange liquidity between themselves in the money market.
Whether Danmarks Nationalbank’s deposit or lending rate is more influential for the Danish Short Term Rate (DESTR), the benchmark overnight money market interest rate, depends on the net position, which is the banks’ total net krone deposits at Danmarks Nationalbank.12 The net position is affected by the size of the government’s account balance, Danmarks Nationalbank’s interventions in the foreign exchange market and changes in banknotes and coins in circulation. Since the financial crisis, Danmarks Nationalbank’s foreign exchange reserves have increased significantly and this has been the main driver behind the increase in the net position. A high net position means that each bank has more liquidity on deposit at Danmarks Nationalbank than it expects to need in the short term. Therefore, each bank is only willing to accept deposits at an interest rate below Danmarks Nationalbank’s deposit rate. DESTR has therefore generally been just below the deposit (current account) rate, see chart 5. At a lower net position, banks may be willing to pay more than the current account rate to cover their liquidity needs.
Chart 5
Danmarks Nationalbank has a unique deposit and lending rate with a relatively low spread between deposit and lending rates
Note:
DESTR is the benchmark overnight money market interest rate in Danish krone and is shown as pre-DESTR prior to its introduction in March 2022.
Source:
Danmarks Nationalbank.
The benchmark money market interest rate, DESTR, has historically been anchored slightly below the current account rate when the net position has been high
Like the euro area, it is unclear exactly what level of the net position is sufficient for DESTR to be anchored around the current account rate. This relationship varies over time as it depends, inter alia, on the banks’ overall demand for central bank liquidity and how it is distributed among monetary policy counterparties. Danmarks Nationalbank’s balance sheet has not increased to the same extent as the Eurosystem’s and unlike the euro area, there has in fact been some recent evidence of liquidity scarcity that has caused reference rates in the Danish money market to rise towards the lending rate.
The legacy overnight reference rate in the Danish money market, the Tomorrow-Next rate (T/N rate), was close to the deposit rate when the net position was above kr. 150 billion, see chart 6. For a net position below that level, the T/N rate tended to rise towards the lending rate. This was the case in 2021, for example. Since its introduction in April 2022, DESTR has not fluctuated with changes in the net position when it has been above kr. 200 billion, see chart 6.13, 14 A net position of kr. 200 billion corresponded to 7 per cent of Danish GDP in 2023, or 2 per cent of the Danish banking sector’s total balance sheet. In comparison, current excess liquidity in the Eurosystem represented 22 per cent and 9 per cent of the euro area’s GDP, and the total balance sheet of the euro area banking sector, respectively, in 2023.
Chart 6
Since its introduction in April 2022, DESTR has been slightly below the current account rate when the net position has been at least kr. 200 billion
Note:
The y-axis shows the spread between the benchmark overnight money market interest rate, DESTR; Danmarks Nationalbank’s current account rate for the period since April 2022; the spread between the previous overnight reference rate, the Tomorrow Next rate (T/N rate) and Danmarks Nationalbank’s certificate of deposit (CD)/current account rate for the period prior to April 2022 and back to January 2016. In the chart, the T/N rate is adjusted by 19 basis points, which is consistent with the process for the transition from the T/N rate to DESTR, see box 1 in Nicolaj Schou Andersen and Nikolaj Bremer Orloff, DESTR is a robust anchor in the Danish capital market, Danmarks Nationalbank Analysis, no. 5, March 2023. The x-axis shows the net position, which indicates the banks’ total net deposits with Danmarks Nationalbank. For DESTR, the last banking day of each month is omitted, while the last two days are omitted for the T/N rate.
Source:
Danmarks Nationalbank.
Danmarks Nationalbank’s monetary policy instruments for implementing
the fixed exchange rate policy are robust to the ECB’s new operational framework
Since the introduction of the euro in 199915, Danmarks Nationalbank has maintained the fixed exchange rate of the krone against the euro through currency interventions and independent interest rate adjustments. These courses of action have worked regardless of how monetary policy has been implemented in the euro area. This has also been the case in periods when volatility of the benchmark overnight rate in the euro area money market has been significant, see chart 7.
The structural scarcity of excess liquidity in the Eurosystem prior to the financial crisis led to significantly larger fluctuations in Eonia compared to the period since 2015 when excess liquidity has been very high, see chart 7. However, analysis by the ECB shows that Eonia volatility between 2000 and 2015 did not have a significant impact on longer-term euro area swap rates with maturities from one month to 10 years.16 This historical lack of relationship does not rule out the possibility that increases in the €STR volatility could affect longer swap rates going forward, however.
Fluctuations in the €STR per se have limited impact on the demand for kroner, as this only affects how attractive it is to invest in kroner on a day-to-day basis. Movements in euro swap rates with a maturity of longer than one month do, however, have a greater impact on the krone’s exchange rate against the euro. These swap rates affect the price of currency hedging between kroner and euros. A typical hedging horizon is three months, where the price depends primarily on the swap spread between euro and krone with the same maturity.
Although the ECB intends to only tolerate a limited degree of volatility in the €STR, it cannot be ruled out that any increase could affect longer-term euro money market interest rates (e.g. three-month maturities). Even if this were to be the case, and the krone exchange rate against the euro were to be significantly affected, Danmarks Nationalbank has the necessary tools for its stabilisation. Danmarks Nationalbank can intervene in the foreign exchange market and, if needed, make an independent interest rate adjustment to its deposit and lending facilities. Danmarks Nationalbank’s current monetary policy instruments are therefore robust to the ECB’s new operational framework for implementing monetary policy.17 In all cases, Danmarks Nationalbank will continue to monitor the need to adjust its monetary policy instruments in order to maintain the fixed exchange rate policy.
Chart 7
Volatility in the €STR was significantly higher in the period prior to the financial crisis and up to the introduction of the asset purchase programme in 2015
Note:
Realised volatility of overnight money market interest rate in the euro area in different periods. APP refers to the ECB’s first asset purchase programme from 2015.
Source:
ECB, Refinitiv Eikon, Danmarks Nationalbank.
The analysis consists of a Danish and English version. In case of doubt as to the correctness of the translation, the Danish version will prevail.
Editing completed on 10 May 2024