In a column for the Nacional weekly, published on 22 August 2023, Deputy Governor Sandra Švaljek explains the side effects of the tightening of monetary policy.

The fact that central banks now pay large sums to commercial banks while commercial banks maintain low interest rates on their clients' deposits seems like an unfair side-effect of the fight against inflation. Should such a situation be rectified – if not by monetary policy measures, then by tax or other economic policy measures?

Descriptions of the modalities of monetary policy implementation are not amusing reading, especially in the summer. But when they become controversial and provoke media and professional attention and reactions from politicians, they become a topic that needs to be clarified and explained. Currently, this status is earned by the interest that banks in the euro area receive on funds deposited with central banks, which is one of the reasons for the significant increase in their total income and profits.

As of mid-2022, the European Central Bank, determined to bring inflation to its target of 2 per cent within an appropriate time-frame, has been pursuing a strong monetary policy tightening primarily by raising the key interest rates – the overnight deposit rate, the main refinancing operation rate and the marginal lending facility rate. At nine consecutive meetings of the Governing Council of the European Central Bank, the deposit facility rate was raised from –0.5 to 3.75%, i.e. by 425 basis points. Due to large liquidity surpluses of commercial banks deposited in their accounts with central banks, such an increase resulted in substantial interest payments to euro area banks and, as a rule, an increase in their total income and profits.

This corollary of the implementation of monetary policy aimed at stifling inflation is seen by many as unjustified subsidisation of commercial banks, which has raised many questions, especially in the light of expectations of a prolonged period of poor financial performance of central banks. Here are the answers to some of them.

Why do central banks pay interest on bank reserves? Central banks started paying interest on commercial bank funds deposited with them in order to enhance the effectiveness of monetary policy. Interest rates on deposits, as well as those on loans to commercial banks, influence the level of all other interest rates and the prices of various types of assets.

Is interest payment on commercial bank liquidity surpluses a specific feature of the Eurosystem or a standard element of modern monetary policy frameworks? Since its inception in 1999, the Eurosystem has been paying interest on the liquidity surpluses of commercial banks; the US Fed introduced this practice in 2008 and it is now also used by the Bank of England, the Bank of Japan and most central banks. However, interest payments to commercial banks have so far been low and thus not attracted attention. Until 2008, banks' liquidity was scarce and there was no accumulation of bank liquidity surpluses in their accounts with central banks. At a time when large-scale asset purchase programmes to support the recovery in the aftermath of the global financial crisis have generated abundant liquidity surpluses, deposit facility rates have been significantly reduced. In the euro area, interest rates were at or below zero over the 10-year period 2012-2022. In other words, while interest payments to commercial banks on their reserves were part of the monetary framework, these payments did not de facto take place.

Why has interest payments on commercial bank reserves now become particularly important? Since the global financial crisis, monetary policies of central banks have been continuously used to support economic growth and counter extremely low and even negative inflation rates, which was achieved through low interest rates and securities purchase and various bank financing programmes under extremely favourable conditions. Banks’ liquidity thus increased, with inflation hitting the banking system in 2021 under an exceptionally abundant liquidity regime. In such circumstances, the basic monetary policy instrument became the interest rate on banks’ deposits in their central bank accounts, rather than the interest rate on banks’ borrowing from central banks. Since it defines earnings from passive liquidity holdings, banks take it into account, with other factors, in decisions on the active management of these funds, i.e. on lending.

What do interest payments to banks mean for the financial performance of central banks and their ability to achieve statutory objectives? It is not difficult to conclude that tightening monetary policy by raising the interest rate on bank deposits is expensive for central banks, i.e. that it significantly increases central bank costs and leads to a fall in profits and possibly losses for central banks. The primary objective of central banks is, however, to maintain price stability, not to make a profit. Given their specific role, financial losses and even complete loss of capital do not prevent central banks from operating and carrying out their statutory tasks. Moreover, in times of crisis such as the period of elevated inflation, central bank losses are justified if they arise as an inevitable consequence of policies aimed at combating inflation.

What does the reduction in central bank profits mean to taxpayers? The fall in central bank profits or their losses mean that central banks will distribute much lower amounts to the state budget this year, and possibly in the coming years, or not at all make profits that they could transfer to the budget. However, this does not necessarily mean that central banks will not contribute to the replenishment of the state budget. Specifically, on funds deposited with euro area central banks, countries can also earn interest at a rate that currently cannot be lower than 0 or higher than the interbank interest rate €STR minus 20 basis points, with each central bank being able to choose the interest rate within the limits thus defined to be applied to government deposits. Most central banks, including the Croatian National Bank, charge interest on funds held in government accounts at the maximum permitted interest rate, which today stands at around 3.45%. It is estimated that by the end of the year, the Croatian National Bank will pay around EUR 460m in interest payments to banks. Government interest income will be much lower, but could amount to between EUR 80m and EUR 90m, an amount that exceeds last year's allocation of CNB profits to the state budget.

Should other economic policy measures correct the consequences of banks’ “subsidisation”? The fact that central banks pay large amounts to commercial banks, while commercial banks maintain low interest rates on their clients' deposits, acts as an unfair redistribution of wealth that should be corrected, if not by monetary policy measures, then by tax or other economic policy measures. However, when considering introducing (or in the case of Croatia continuing to apply) a top-up tax on banks, it should also be taken into account that such a tax should be carefully designed so as not to cause undesirable market reactions or adversely affect financial stability if it were to ignore that an increase in interest rates leads to an increase in banks' credit risk and related costs. In addition, as much as the payment of interest on the funds of commercial banks held in their accounts with central banks seems to be a negative consequence of monetary policy, the question is whether its correction is necessary given that the financial performance of central banks will gradually recover.

What can we learn from this episode? Irrespective of the actions of other economic policy makers, central banks will draw lessons for the future from an episode of a sudden monetary policy reversal. One reason is the potentially negative side-effects, such as high interest payments to banks, and the other is that the implementation of an asset purchase programme to support growth on an ongoing basis also implies a commitment to apply it in the long term, and such a commitment cannot be met if circumstances unexpectedly change. In a new cycle of accommodative monetary policy implementation, central banks are likely to be more cautious about the volume and length of implementation of quantitative easing programmes and the build-up of banks' liquidity reserves.