Monetary dynamics during the tightening cycle

Since mid-2022, banks have raised deposit rates in response to a series of interest rate hikes by the European Central Bank (ECB), totaling 450 basis points. Interest rates on new time deposits increased by 372 basis points and overnight deposits by 50 basis points. However, these rates still trail historical norms, especially for household overnight deposits.

In October 2023, the average annual interest rate offered to euro area firms was 3.70% and to households 3.27% for new time deposits with up to two years maturity. The spread relative to the policy rate was -30 basis points for firms and -73 for households. For overnight deposits, remuneration remains significantly lower than the policy rate, widening during tightening cycles due to high switching costs and banks’ market power. This spread was notably wider in October 2023 than during the 2007-08 period but comparable to the 2000 cycle.

Deposit rates have seen limited change, influenced by previous periods where deposit rates exceeded the policy rate and weaker transmission to household overnight deposits. The ‘deposit beta’ ratio, which measures the strength of pass-through from policy rates to deposit rates, varies based on the starting point of the cycle. During the current cycle, the ending of negative and low interest rates led to only minor increases in deposit rates.

Significant shifts from overnight deposits to time deposits and bonds have occurred due to increased remuneration, changing the investment landscape for firms and households. This trend reflects the higher opportunity cost of holding overnight deposits compared to previous low-interest periods.

Monetary policy changes also impact money creation through credit provision and central bank activities. The current tightening cycle has reduced broader money creation, with lower loan demand and supply, and the contraction of the Eurosystem balance sheet. Consequently, the annual contribution to M3 money supply from loans to firms and households decreased significantly.

Lastly, the shift from overnight deposits has led to an unprecedented contraction in the narrow monetary aggregate M1, traditionally a predictor of real GDP growth. This trend raises concerns about economic slowdown, although the impact may be moderated by the ongoing shift from overnight deposits and the high stock of these deposits by historical standards.