Towards a new monetary policy paradigm for the European Central Bank

Since January 2013, the inflation rate has mostly been below its target of “below, but close to 2% over the medium term”. In fact, inflation has been unexpectedly low across much of the developed world and economists speak of a “missing inflation” puzzle. Also, there is evidence of a downward trend in inflation due to the decline in inflation expectations while other deeper factors may also be at work. In the current situation of deflation, monetary policy needs to be reformulated and it should fully take into account the conditions that affect the monetary transmission mechanism. This might require the adoption of a new approach that also brings to an end to the “one size fits all” approach pursued the European Central Bank and adapt the monetary instruments to each country specific situation. The heterogeneity of the euro zone is illustrated by the map showing ratings by Standard & Poor (S&P).

To achieve its main objective of maintaining price stability in the euro area, the European Central Bank (ECB) uses nominal interest rates – and also other measures – to affect financing conditions in the economy, including negative interest rates introduced in June 2014 and other non-standard measures (e.g. purchased debt securities, targeted long-term refinancing operations, Outright Monetary Transactions). Also, the ECB began “forward guidance” in July 2013 to provide information about its future monetary policy intentions. In 2017, the ECB President, Mario Draghi, observed that reflationary dynamics were “slowly taking hold” and the Governing Council of the ECB declared that deflation had ceased to be a concern. But, despite an aggressive accommodative monetary policy, the ECB has failed to bring inflation close to target and to revamp economic growth. Against this background, the President of the ECB, Christine Lagarde, said “we are fully flexible, we will look at all options, we will determine and monitor and we will make sure that our monetary stance and our monetary policy transmission are both effective”. But how credible is this against the background of failure to achieve targets so far.

Vítor Constâncio, Vice-President of the ECB, said in 2018 “we should remain aware that the precise channels of transmission of Quantitative Easing (QE) are still imperfectly understood”. Also, a commonly held view is that conventional monetary policy becomes ineffective when policy rates reach the zero-lower bound. Back in 2018, Vítor Constâncio added that “negative rates and reverse repos belong now to the monetary policy toolkit to be used whenever necessary” and indeed, policy rates have been lowered since then. Recent research within the ECB has questioned the existence of such a zero lower bound and has found that the bank lending channel is not impaired by negative money rates. Today, the ECB is reluctant to further lower the monetary rates and part of the banks’ excess liquidity holdings reserves – about €800 billion – has even been exempted from negative rates precisely to support the bank-based transmission of monetary policy.

Isabel Schnabel, Member of the Executive Board of the ECB, has portrayed narratives about the ECB monetary policy as fiction and the public criticism as based on perceptions and not on facts. She has dismissed criticism of side effects, including the effects of monetary policy on income and wealth distribution, effects on the corporate landscape – emergence of “zombie firms” -, the effects on asset prices and financial stability at large. Brushing aside such criticism, she affirms that “in order to maintain price stability, central banks around the world had to resort to a number of unconventional instruments in order to bring inflation back to a level that is consistent with their medium-term inflation aim”. To Gauti Eggertsson and Michael Woodford, the acquisition by the central bank of a variety of types of assets are irrelevant or neutral, in so far, these open market operations do not change the expected future conduct of monetary policy.

Isabel Schnabel is nevertheless right about highlighting that the level of the real equilibrium interest rate is determined by a number of structural factors beyond the control of the ECB. Among these factors, Isabel Schnabel cites country’s demographic situation and capacity to innovate. The declining and even negative real equilibrium interest rate suggests that the supply of capital is matched with relatively low demand – in other words that the desire to save is meeting with a comparatively low propensity to invest. She recognizes that in the current situation the scope to stimulate the economy by cutting interest rates is greatly reduced because monetary policy is constrained by the zero lower bound. She points out that the fall in long-term trend economic growth stems from declining factors of production, as well as efficiency. The trend is compounded by recent massive changes, including moving away from capital intensive industries. Isabel Schnabel concludes that “it is not within the power of the central bank to change the structural conditions that would turn around the negative interest rate trend”.

Christine Lagarde has underscored that the ECB “will not accept fragmentation of monetary transmission in the euro area”. Also, the ECB’s role is “ensuring that our monetary policy is transmitted to all parts of the economy and to all jurisdictions in the pursuit of our price stability mandate”. The problem is that the euro area is a heterogeneous group of countries – economic differences, variations in financial structures, public deficit and debt – that are “only partially functioning as a cohesive unit”. focusing on monetary policy transmission through the bank lending channel over the period 2002 to 2016, Ayla Oğuş Binatli and Niloufer Sohrabji found an unexpected positive relation between a shock to short-term interest rates and inflation, as well as evidence that bank lending is an appropriate, albeit a weak, mechanism for monetary policy transmission in the euro zone. Transmission to output appears to be somewhat stronger in more financially developed economies, but the opposite is true for the transmission to prices.

Source: Luis Brandao-Marques, Gaston Gelos, Thomas Harjes, Ratna Sahay, and Yi Xue (2020): Monetary Policy Transmission in Emerging Markets and developing countries. IMF Working Paper.

According to the interest rate channel, an increase in nominal interest rates translates into an increase in real rates and the user cost of capital, given some degree of price stickiness. The 2007 financial crisis has disrupted the pass-through of policy rates onto market rates, particularly for the long-term rates, while the transmission to the short rates has been less affected. Although the degree and the speed of pass-through vary. The pass-through has also become less reliable, reflecting most likely the dislocation of the markets for short-term bank financing. The transmission to lower grade corporate bonds seems to have been particularly negatively affected, following the crisis. Also, it found some evidence that the ECB’s non-standard measures, namely the lengthening of the maturity of monetary policy operations and the provision of funds at the fixed rate, have facilitated the pass-through through the reduction of money market term spreads. Furthermore, the results imply that the substantial increase in the ECB’s balance sheet may have contributed to a reduction in government bond term spreads.

The interest rate channel is the most important for monetary policy transmission in the euro area and that the bank lending channel also plays a role, with different relative importance in different euro area countries. Higher real rates lead to a postponement of consumption and a reduction in desired investment, exerting downward pressure on prices. At the same time, it leads to a stronger currency, which puts downward pressure on the prices of tradable goods in the consumer price basket and to a stronger exchange rate. The latter typically leads to a reduction in both net exports and the overall level of aggregate demand. An opposite pressure can take place in the presence of currency mismatches whereby an appreciating currency may strengthen borrowers’ and lenders’ balance sheets – increasing their ability to borrow and extend credit – and thereby stimulate the economy. The time needed for the policy feedback to pass-through has increased significantly since the financial crisis.

Matteo Ciccarelli and Chiara Osbat have found that over the period 2012-2016, the missing inflation – actual lower than expected inflation -was primarily due to domestic factors in the earlier part of the period and global in the latter part. The Phillips curve – stable and inverse relationship between inflation and unemployment – remains a useful tool in understanding inflation dynamics in the most recent disinflation, with a strengthening of the sensitivity of inflation to economic slack recently and an emerging de-anchoring of inflation expectations. Also, they revealed signs of increased inflation persistence. They also found robust evidence on the effectiveness of the Asset Purchase Programme (APP) in re-anchoring inflation expectations. To some, the apparent disconnect between wage and price developments in Europe in the last few years remains a puzzle, as wages have risen faster than productivity in many European countries. Vizhdan Boranova and others found that the weaker pass-through between wages and inflation is associated with a subdued inflation and inflation expectations are better anchored, higher aggregate corporate profitability, and in sectors more exposed to competition.

The broad credit channel works through the net worth of firms. Under the bank lending channel, tight monetary policy drains liquidity and deposits from the banking system and induces cuts in lending if banks face frictions in issuing uninsured liabilities to replace the shortfall in deposits. In addition, high short-term rates (together with a downward-sloping yield curve) depress bank profits and reduce their net worth, further hindering their ability to issue non-deposit liabilities. In the presence of financial frictions
(imperfect information and costly enforcement of contracts), monetary policy affects the financial position of borrowers and the relative cost of external and internal funds. Quantitative easing policy inflates the central bank’s balance sheet, boosting its securities portfolio on the assets side and the current accounts of resident banks on its liabilities side. At the same time, the banks’ reserves with the central bank show large surpluses compared with minimum requirements and customer deposits with the banks show a strong growth. Moreover, when non-bank agents sell treasury securities and settle transactions via the banks, they increase the size of the banks’ balance sheets, by increasing their deposits with the central bank and their debts to customers and thus increasing both the monetary base and monetary supply. Normally “loans create deposits” but quantitative easing can lead to growing deposits with even declining loans.

The above clearly shows that country characteristics such as financial market development, institutional policy frameworks and other specific factors affect the transmission of monetary policy through the various channels. We also note that the exchange rate monetary policy transmission channel affects countries differently, but individual countries cannot use the exchange rate to dampen or strengthen the monetary transmission. It is thus likely that symmetric decisions by the ECB will lead to significant variations in outcomes, with gainers and losers or uneven impacts. Differences in the liquidity, the structure of interbank money markets, and overall financial development, market segmentation, access to financing and liquidity positions of banks are likely to matter for the transmission of policy rates to the economy through the interest rate channel.

When monetary rate policy alone is insufficient to ensure perfect stabilization, secondary instruments can help smooth economic fluctuations, though in some circumstances, committing not to use the second instrument may be welfare improving. In practice, the “divine coincidence” – the twin objectives of stable inflation and zero output gap coincide – can break, requiring the use of additional non-conventional measures, such as balance sheet operations (quantitative easing), sterilized foreign exchange (FX) intervention, macro-prudential policy, fiscal devaluations, etc. However, little is known about the use of such non-conventional instruments and their impact on economic output, inflation and side-effects.

Vasco Curdia and Michael Woodford distinguish between “quantitative easing” in the strict sense and targeted asset purchases by a central bank and conclude that neither is a perfect substitute for conventional interest-rate policy. They argue while the former is likely be ineffective at all times, purchases of illiquid assets can be effective when financial markets are sufficiently disrupted and the zero-lower bound on the policy rate is reached. Credit policy is thus only a relevant additional dimension of central-bank policy to the extent that financial markets fail to fulfil that function. The mere size of the increase in credit spreads and that the zero bound has been reached are not sufficient to judge the benefits of active credit policy. The primary justification for undertaking non-traditional asset purchases should relate to conditions specific to the markets for those assets only and not linked to the level of the policy rate.

Gauti Eggertsson and Michael Woodford contend that the key to dealing with a situation like the current one in the least damaging way is to “create the right kind of expectations. In this respect, the ECB uses “forward guidance” as an important element of its monetary policy and defines it as providing information about its future monetary policy intentions, with regard to the expected future path of key interest rates, but also with regard to the horizon of its asset purchase programme. For Gauti Eggertsson and Michael Woodford, the right kind of expectations involves a commitment to history-dependent policy of a sort, regarding the way in which monetary policy will be used subsequently, at a time when the central bank again has room to manoeuvre”.

Implementation of the proposed monetary policy requires a commitment to a policy rule that specifies the central bank’s short-run targets at each point in time as a fairly simple function of what has occurred prior to that date, for example by keeping the gap-adjusted price level fixed at all times. Note that there is no longer a need for estimating the natural rate of interest to implement this constant price-level targeting rule and that the an “automatic stabilizer” built into the price-level target, that is lacking under a strict inflation targeting regime. Moreover, country specific targets can be set in terms of gap-adjusted price levels, while keeping the interest rate policy symmetric. Successful implementation of the proposed approach hinges on a precondition that the central bank itself clearly understands the kind of history-dependent behaviour to which it should be seen to be committed, as well as to communicate and act consistently.

Some actions may well be used just to help create desirable expectations regarding future policy. A commitment to supply base money in proportion to the target price level, in a period in which the zero bound prevents the central bank from hitting its price-level target, can be desirable both as a way of ruling out self-fulfilling deflation and as a way of signalling the central bank’s continuing commitment to the price-level target. To demonstrate publicly that it expects to carry out its commitment regarding future interest-rate policy, the central bank may want to carry out open-market purchases of long bonds, which could lower long-term interest rates and stimulate the economy immediately, provided such open-market purchases are seen in this light of indicating resolve. Purchases of foreign exchange by the central bank provide, accompanied by depreciation of the exchange rate, is one way for the central bank to demonstrate its own confidence in its policy intentions. Another way of increasing inflationary expectations is for the government to cut taxes and issue additional nominal debt or funding through money creation.

In the above, we have contrasted the views of the ECB with those of Gauti Eggertsson and Michael Woodford on the conduct of monetary policy, notably in a situation of low both economic growth and inflation. Differences arise not only in respect to the monetary policy itself but also the monetary policy mechanism. While the ECB seems to feel paralyzed by the low interest rates, though it claims to have had some success in using quantitative easing, Gauti Eggertsson and Michael Woodford propose a different approach, which is “type of history-dependent price-level targeting rule with the property that a commitment to base interest-rate policy on this rule determines the optimal equilibrium, and that the same form of targeting rule continues to describe optimal policy regardless of which of a very large number of types of disturbances may affect the economy”.

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