Government deposits, held by national treasuries, local government entities and EU bodies such as the European Stability Mechanism and the European Financial Stability Facility, impact the liquidity conditions in the Euro area. This, in turn, affects the ECB’s monetary policy pass-through rate.
Money market spreads
Government deposits were previously remunerated at a fixed rate of 0% before the introduction of a negative deposit facility rate (DFR) in June 2014. When the DFR was lowered to below 0%, a ceiling was introduced on the remuneration of government deposits, set at the lower of the DFR or the relevant money market rates. This ceiling remained in place for as long as the deposit facility rate remained below zero.
Money market rates, which reflect the rates at which banks and other financial intermediaries lend and borrow cash for short periods, typically 1 day, and no more than 1 year, have traded below the DFR for several years.
The euro short-term rate (€STR), which is the benchmark rate for uncollateralised loans with a 1-day maturity, has consistently traded between 8 and 10 basis points below the DFR, and has increased almost exactly in line with the ECB’s monetary policy rate hikes since July 2022, suggesting a high pass-through rate of up to 99%, without delay.
To maintain the effectiveness of monetary policy transmission, the ECB, when raising the DFR above 0% in September 2022, decided to temporarily remove the 0% remuneration ceiling until 30 April 2023.
However, most money market transactions are collateralised, meaning the borrower pledges securities such as government bonds to the lender as collateral. Despite this collateralisation, transaction data shows that the transmission in this market has been limited, with the average pass-through rate for German and French repo rates ranging between 86% and 95% during the November 2022, compared to policy rate hikes.
Based on a working paper by the IMF, it was estimated that the scarcity of high-quality assets, such as government bonds, for use as collateral results in a 0.78 basis point decline in the repo rate for every 1% increase in outstanding bonds purchased. This inelastic decline can impede the transmission of policy rates to the money markets.
On 7 February 2023, the ECB announced that it would set the ceiling for the remuneration of euro area government deposits, effective from 1 May 2023, at the €STR minus 20 basis points. The ECB noted: “There is persistent collateral scarcity in some segments, and banks are still constrained in their ability to intermediate a substantial amount of excess liquidity.”
By offering a remuneration rate of minus 20 basis points €STR, the ECB is providing incentives for national treasuries, local government entities and EU bodies to spend their deposits, thereby easing the collateral situation in the market, and in turn result to a higher monetary policy transmission.