The Effective Rate of Interest on Target Balances

According to formal decisions of the ECB’s Governing Council, Target and cash balances carry a rate of interest equal to the ECB’s main refinancing rate. However, the Council also decided that all primary interest income of the NCBs is pooled and redistributed according to country size. The pooling eliminates the statutory interest on the balances, but at the same time it implies an effective rate of intra-Eurosystem interest on them, given that the balances measure international liquidity flows that cause changes in the primary interest incomes collected by the NCBs, which is neutralized by pooling. The effective rate of interest on the balances is a weighted average of the ECB’s policy interest rates where the weights are determined by the structure of the sources and sinks of international liquidity flows that are measured by the Target balances. As the intra-Eurosystem interest payments are booked as additional Target balances and imply secondary liquidity flows from the Target debtor to the Target creditor economies, pooling actually implies compound interest. Usually, the effective rate of interest is positive, but with the ECB’s current set of policy interest rates, its sign has turned negative.