Monetary dynamics during the tightening cycle

The current monetary policy tightening cycle has led to increases in bank deposit rates, albeit to a lesser extent than in the past. In part this reflects the transition from negative interest rates to rates well into positive territory. When interest rates were very low, spreads between deposit and policy rates became compressed or even negative, as banks were reluctant to charge negative rates to their retail depositors. Consequently, some time was needed in the initial phase of the current tightening cycle for spreads to normalise. During that period, policy rate hikes were matched by only minor increases in deposit rates. The current round of monetary policy tightening has had an impact on portfolio allocation by incentivising shifts from overnight deposits to time deposits and bonds. It has also weakened money creation by (i) bringing credit expansion to a halt, (ii) reabsorbing money in circulation as the Eurosystem’s monetary policy portfolio contracts, and (iii) leading banks to repay central bank funding and replace it with long-term bonds. Both portfolio shifts and the contractionary monetary dynamics have resulted in negative growth rates of unprecedented size for M1 and M3. JEL Classification: E41, E43, E44, E51, E58, G11