By Aaron Tornell and Frank Westermann

"Should the inflation outlook worsen, we would immediately take preventive steps". So said Mario Draghi, President of the European Central Bank. This column argues that these are brave words given that the ECB has hit a limit in its ability to prevent an acceleration of inflation.

In December, the ECB successfully forestalled a financial crisis by stepping in with a big bazooka and inundating the market with liquidity. Unfortunately, the big bazooka has come at a cost; the composition of the ECB's balance sheet has changed dramatically.

Under standard monetary policy, when there is a sudden increase in money growth, the central bank can increase its short-term interest rate and thereby reduce its short-term loans to banks. This policy causes a reduction of bank lending to households and firms, which absorbs excess liquidity and prevents an acceleration of inflation. The ECB has lost its ability to implement this type of anti inflationary policy.

As seen in Figure 1, the short-term deposits of banks at the ECB in excess of the minimum requirements ? the so-called excess reserves ? have experienced an unprecedented increase: from €199 billion in September 2011 to €792 billion in March 2012. These short-term excess reserves can be withdrawn by banks in a sudden manner and now represent 26% of the ECB's balance sheet.1, 2

If banks chose to withdraw their deposit or inflation started for any other reason, could the ECB follow the standard policy and raise short-term interest rates? No, because this policy instrument is not available to the ECB anymore; its short-term lending to banks has practically hit zero. It has collapsed from €201 billion in September to €18 billion in March. Presently, the ECB's short-term loans to banks represent only 0.6% of its balance sheet.

In principle, the ECB could take other actions to absorb an excessive increase in liquidity. It could:

  • Increase minimum reserve requirements;
  • Sell assets other than its short-term loans to banks; or
  • Increase the interest rate on bank deposits at the ECB to discourage banks from making withdrawals.

Let us consider each in turn.

Is the ECB likely to increase the minimum reserve requirements in the foreseeable future? The short answer is no. In fact ? as part of the big bazooka ? the ECB reduced the minimum reserve ratio from 2% to 1% on 8 December 2011. As a result, minimum reserves fell by a remarkable €104 billion in February 2012, as shown in Figure 2.3

In the next few years, the ECB will find it exceptionally difficult to increase minimum reserve requirements because there is a sharp asymmetry of excess deposits across countries. While in some countries the excess of deposits over minimum reserves is quite high (eg €313 billion in Germany), in other countries there are practically no excess deposits (eg €1.5 billion in Italy). Therefore, if the ECB were to increase minimum reserves, there might be systemic bank failures among these low excess deposit countries. Since the ECB cannot discriminate by increasing minimum reserves for some countries while not for other countries, it will likely keep minimum reserves at low enough levels so that none of the countries risks a liquidity squeeze.4

Could the ECB instead sell other assets in its balance sheet to mop up liquidity? To illustrate why it will not be easy for the ECB to do so, let's consider a generous rule which permits the ECB to dispose of all its assets at short notice, except those 'sensitive assets' that are clearly difficult to dispose of. As Figure 3 shows, even under our assumed scenario, this upper bound on the share of 'non-sensitive assets' that the ECB could sell at short notice has fallen to 26% of the balance sheet. Considering that total excess deposits amount to 34% of the balance sheet, the ECB would not have enough non-sensitive assets to sell in order to cover a withdrawal of excess deposits by banks. March 2012 is the first time since the creation of the ECB that the upper bound on non-sensitive assets is below excess deposits. Clearly, the ECB has hit a critical limit.

Figure