ECB needs action plan to battle rising rates

Call it the law of unintended consequences: two years ago the European Central Bank pumped more than €1tn of loans into the eurozone's financial system to prevent a financial collapse. But as banks accelerate their payback a steepening rise in short term money market rates threatens to raise borrowing costs and choke the region's tentative economic recovery.

Last week Mario Draghi, the ECB president, said the bank was ready to intervene again if money market rates went too high, part of official plans to maintain an "accommodative" monetary policy and provide cheap credit to bolster the eurozone's fragile economic growth.

One month euribor, a benchmark interest rate in money markets where banks and companies access crucial short-term finance, is at its highest level since mid-2012, excepting seasonal variations, after rising by more than a fifth to 0.208 per cent since the beginning of December. Similarly, the eurozone's key overnight interest rate, dubbed 'eonia', rose by 36 per cent to 0.153 per cent and the weekly rate increased by 40 per cent to 0.174 per cent over the period.

"It ties in with the prospects of the eurozone recovery," says Charles Diebel, head of market strategy at Lloyds bank. "When the ECB did the LTRO it had a hugely beneficial effect on money market rates by bringing them down and convincing people that rates would be kept on the floor for a long time - any kind of rebound is counter to that."

Mr Draghi's warning came in the wake of the largest surge of funds back into the ECB since February last year as banks paid back €43.2bn they had borrowed from the ECB in 2011-12 under its 'longer-term refinancing operation'.

The combined payments of the past four weeks mean banks have paid just over half the first round of LTRO and more than a third of the second round according to ECB data. There is €569.7bn outstanding.

That has led to a draining of what regulators' call 'excess liquidity' from the region's financial system, pushing short term rates higher.

"The ECB's worry is that this increases the cost of credit in the real economy," says Alessandro Tentori, head of rates strategy at Citi. "It's concerned with the overall tightening of economic conditions defined by eonia's effect on real interest rates and the appreciation of the euro against other currencies."

The European Central Bank has given little steer on what threshold interest rates would have to cross before intervening.

In determining whether to act, the results of the ECB's liquidity auctions, which it uses to dole out cash to the banking system, will be key. The auctions, which let lenders access as much central bank money as they want, allow the ECB to gauge banks' demand for liquidity.

Mr Draghi has emphasised that there is no mechanical relationship between excess liquidity and money market rates in the short term.

However, the past also offers some guide to what could prompt action. A rise in short-term money market rates over the summer, largely on the back of speculation that the US Federal Reserve would begin to taper its bond purchases, prompted the ECB to reassure markets and the public that interest rates would remain low, a policy approach known as forward guidance.

This time around, economists believe an "unwarranted" rise in money market rates is most likely to lead to cuts to the ECB's benchmark main refinancing rate, which is already at a record low of 0.25 per cent.

"For me, what they should do is straightforward: cut rates," says Richard Barwell, economist at Royal Bank of Scotland.

The central bank could also pump more cash into the market. "The ECB could act with a view to ensuring a sufficiently large amount of excess liquidity for a sufficiently long period that would prevent a rise in money markets," says Jacques Cailloux, eurozone economist at Nomura.

Others argue the focus on rates creeping upwards is overblown.

Mr Tentori says rates could climb significantly higher without much economic fallout.

"In balanced liquidity conditions historically eonia has fixed at about 7-8 basis points above the ECB's refinancing rate, which is currently 0.25 per cent," he says. "Therefore we could double the present eonia rate without too much detrimental effect."

Either way caution is the order of the day. Having been used to low money market rates for over a year any surprise increase could prove a shock to the economic system.

"It's like trying to get a dipsomaniac drunk - you give it alcohol because you eventually want it to come out of the system," said one London-based banker. "You don't want it to go cold turkey."

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