Target2: The New QE .... and QT

To solve US funding problems, the Fed has willingly and unambiguously taken the dysfunctional US wholesale money markets and essentially put them on to its balance sheet. The ECB has indirectly, unconsciously and, possibly, unwillingly done the same through the Target2 system. The Target2 balances measure the cumulative balance of payments disequilibria between Eurozone economies. More accurately they underpin these disequilibria because Target2 is an automatic lending system that prevents the need for the deficit economies to adjust.

This was not, of course, how the system was designed. No one truly foresaw that the wholesale funding markets could disappear for so long and that the ECB would be compelled to finance these funding needs for years. Consider an example. Say, a Spanish bank loses deposits for whatever reason to a German bank – capital flight or trade. Normally, the Spanish bank would either correspondingly reduce its loan book (and investments) or replenish the funding by borrowing indirectly from the German bank through the wholesale money market. Credit concerns now rule this out, so instead the Spanish bank effectively borrows from the ECB (via the Bank of Spain). The German Bank can now choose either to increase its overall lending; increase its reserve balance at the ECB or reduce any borrowings it has from the ECB. The actions of Spain keep the Spanish component of the Eurozone monetary base intact; the actions of Germany will increase the German monetary base if German banks build up their reserves, or leave it unchanged, if the banks pay off ECB loans. Commercial forces likely push the German bank to maintain its funding and build up reserves, thus increasing the German component of the Eurozone monetary base.  Adding these bits up, the total Eurozone monetary base should rise and fall pari passu with the Target2 balances.

The actual data tell a staggering story: over the period since the Euro started in 1999, the correlation between the Eurozone monetary base and the size of German Target2 balances (both measured in Euros) is 0.027; from 2009 this jumps to 0.511; from 2010 to 0.623 and since 2011 to 0.787. From 2012 onwards, it hits a whopping 0.954, showing that the two series move virtually step-for-step. They are indistinguishable. Therefore, the latest fall in Target2 and the associated drop in the Eurozone monetary base shows a inadvertent tightening of monetary conditions. We have been warned.