The European Central Bank has announced a new monetary policy framework, establishing a system of interest rate floors and devolving more power to banks.

The European Central Bank proposed a new monetary policy framework on Wednesday, establishing a lower limit system for interest rates and granting more power to banks to decide on the amount of cash needed for their operations.

Media reports indicate that this reform aims to support the core mission of the European Central Bank in maintaining price stability in the euro area. It will allow banks to determine how much liquidity they need, in addition to what is provided by a new permanent bond portfolio from the ECB.

Analysts believe that although no timetable has been given for the transition to the new policy, the process will be lengthy due to the significant funds from past stimulus measures still in the system.

At the end of 2022, the European Central Bank stated that the rate hikes following the Russia-Ukraine conflict marked the end of years of ultra-low and even negative interest rate policies, as well as large-scale bond purchases to recapitalize banks and boost the economy. The ECB will reassess its operational framework. Since September last year, the ECB's deposit rate has remained at a record 4%, even as the region's economy has experienced over a year of stagnation. However, with inflation trending towards the 2% target, the ECB is expected to cut rates starting in June.

The newly announced policy acknowledges the "significant changes in the financial system and monetary policy in recent years," said ECB President Christine Lagarde in a statement. "This framework will ensure that our policy implementation remains effective, robust, flexible, and efficient."

According to the announcement, the ECB plans to establish a lower limit system for interest rates, with the lowest of the ECB's three policy rates being a key lever for changing short-term borrowing costs. "Short-term money market rates are expected to fluctuate near the deposit facility rate, allowing for some volatility as long as it does not blur the signal of the expected monetary policy stance," the ECB stated on Wednesday.

Regarding bond operations, under the new rules, the current bond holdings will continue to be phased out, but the ECB will provide liquidity through a new structured asset portfolio. The new portfolio will inject cash without using scarce collateral from recent years, include shorter-term bonds, and may help the ECB achieve its climate goals.

In terms of refinancing operations, while banks are given the authority to decide how much operating capital they need, the ECB stipulates that the gap between the deposit rate and the main refinancing rate will narrow from the current 50 basis points to 15 basis points on September 18, achieved by lowering the main refinancing rate (MRO) by 35 basis points.

"This narrower interest rate spread will stimulate bidding in weekly bond operations, potentially causing short-term money market rates to fluctuate near the deposit facility rate," the ECB stated. "At the same time, it will create room for market activity and provide banks with incentives to seek market-based funding solutions."

In addition to the main refinancing operations, the ECB stated that liquidity will be provided through three-month longer-term refinancing operations and structural longer-term lending operations in later stages. Strategists generally expect that loans will make liquidity more accessible, thereby suppressing volatility and helping ensure that money market rates remain anchored to policy rates. In addition, the minimum reserve requirement for commercial loan institutions deposited in European banks will remain at 1% of specific liabilities, but may be adjusted in the future.

Analysts believe that due to the significant excess cash still present in the European Central Bank system, any immediate market reactions may be subdued. The changes announced on Wednesday do not have a direct impact on monetary policy, as monetary policy had already been rapidly tightened before.

The European Central Bank stated that the Governing Council plans to review the "key parameters" of the new framework in 2026, while being prepared to make adjustments in advance when necessary. They also intend to conduct a "thorough analysis" of the new long-term refinancing operations and the design of new structural portfolios, although the European Central Bank did not provide details.