ECB Monetary Policy

I've been looking at interest rates in Europe over the past few days, and there's an interesting dynamic going on. "Interest rates" in Europe, meaning the European Central Bank's policy rate, are 1%. But money market rates for interbank lending, i.e., the European equivalent of the Fed Funds rate, are much lower. In effect, the ECB is running a zero-interest-rate policy by stealth.

First, some background on how the ECB conducts monetary policy.

The vast majority of the euros in circulation are lent to the European banking sector for a 1-week term against high-quality, euro-denominated collateral. The lending is carried out at the ECB policy rate, which is currently 1%. Money is lent to any bank that bids for funds, and no bank is forced to do so.

Banks will only borrow from the ECB in this way if it is their cheapest source of funding. But right now, it isn't. 1-week Euribor, which is the rate the best banks charge each other for loans, without collateral, is about 0.35%. So, if you're a financially secure European bank, you have the choice of borrowing at 1% from the ECB and having to post collateral, or borrowing at 0.35% on the market without collateral. This choice is a no-brainer! You're going to borrow on the market.

However, somebody has to be borrowing from the ECB at 1%, because this is the only way that euros get into circulation. If nobody did, all the euros would be stuck at the ECB and there would be no money in the economy! Clearly, this is not happening. So who is borrowing at the policy rate? Most likely, it's the weaker banks in countries like Spain and Greece that can't get funding on attractive terms in the market.

Usually, when weaker banks that can't get good funding in the market borrow from the central bank, they do so by accessing the so-called "discount window," and at a penalty rate. But in Europe, because only "bad" banks borrow at the policy rate, the policy rate of 1% is the penalty rate, while the good credits borrow at 0.35% on the open market.

This 0.35% is the "true" interest rate in Europe, and it offers a different perspective on whether the ECB's policies are actually so different from the Fed's.