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Executive summary:
Together with pushing the deposit facility rate into negative territory, in recent years, the ECB has focused on using a broad range of instruments, including forward guidance on the forthcoming path of the EONIA, outright balance-sheet policy through its (Expanded) Asset Purchase Programme, and targeted LTROs.
• The observed extent of stubbornly low inflation expectations certainly poses a challenge in terms of consistently and proactively responding to shocks that might delay convergence to the ECB’s (medium-term) inflation objective. To this end, in a world of subdued growth prospects (i.e. secular stagnation), forward guidance is regarded as a crucial step to providing the necessary statecontingency of policy to revive the euro area economy. It is vital, at the same time, that the central bank will remain available to maintain the most effective tools to deliver on its mandate. The decision, among others, of 12th September 2019 of the ECB’s Governing Council meeting to restart its net purchases “for as long as necessary” under the APP confirms this necessity.
• As it stands, the package of measures that the ECB announced in September 2019 include a further deposit facility rate reduction; additional open-ended balance-sheet purchases starting in November 2019; a new (pre-announced) round of TLTRO, with the introduction of a two-tier system for reserve remuneration.
• While the evidence suggests improved financing conditions and improved macroeconomic performance overall as the result of QE, the association between core inflation and longer-term expectations, based on the Survey of Professional Forecasters, has weakened again recently.
• In discussing the limits that politics and credit risk may create in making quantitative easing more aggressive, we ask whether the economic slack is a fiscal, rather than monetary, issue. In particular, the question remains as to which other instruments the ECB will still have in its arsenal. Those could be summarised as:
o Unconstrained monetary policy, i.e. the ECB could embark into ever more negative interest rates, by so-doing relieving the government from using fiscal policy; o Extension of asset purchases, as well as changes to its technical rules;
o Outright money creation to support aggregate demand, in the form of direct cash transfers to economic agents or other measures of outright finance via the central bank’s balance sheet (also referred to as ‘helicopter money’ or central banks ‘going direct’, respectively);
o Lifting the optimal inflation target in order to achieve the anchoring of expectations.
• The extension of asset purchases could be both qualitative, i.e. an extension of asset purchases particularly in the realm of corporate sector bonds – as well as the purchase of other risky private assets including equities (such as exchange-traded funds or ETFs); and quantitative, i.e. purchasing larger amounts by lifting the issuer and issue limits of the PSPP and/or deviating from the Eurosystem’s capital keys.
• The Governing Council has faced calls to raise or even overthrow the self-imposed issue and issuer limits on the PSPP and to reconsider its adherence to the capital key. The ECB itself assumesto have broad technical discretion over these limits: particularly, the increasing scarcity of bonds in a number of jurisdictions had to be offset by increased purchases in other jurisdictions, above and beyond the predicted capital key shares.
• While buying equity/ETF purchases would mark uncharted territory for the ECB, risk-taking and potential balance sheet losses would, in theory, carry less of a political threat in the euro area given the ECB’s far-reaching independence. At the same time, the finance ministers of the Member States have not provided the ECB with an explicit recapitalisation guarantee.
• Arguably, expansionary fiscal policy – in conjunction with continued expansionary monetary policy – could boost aggregate demand, and therefore push wage and spending growth up, resulting in a substantial rise in GDP and inflation.
• The empirical evidence reviewed in this note finds that spending policies are more effective in expanding output during less turbulent times when less uncertainty prevails. In addition to that, unless the intertemporal effect of debt is taken into account, the fiscal multiplier tends to be biased and overstated. This means that debt in the euro area represents an important constraint on potential growth, and therefore fiscal expansion is likely to have limited (although) positive impact, specifically in fiscally constrained countries.
• Considering that financial policy – both micro-and macroprudential – has gained much significance since the Great Recession, the scope of conventional monetary policy has been significantly reduced. The ‘new monetary policy’ should be much more considerate of low growth prospects, the interplay between macroeconomic-and financial cycles, private sector balance sheets, and interaction with other policies, in particular, financial policy.
• In this respect, having the ECB to target an inflation interval, of for instance between 1.5-2.5%, also going beyond the current target of 2%, might be a more effective way to proceed, as the evidence suggests, particularly considering the significant uncertainty on the expected inflation path and the context of structural change and demographic shift taking place.
• Other structural policies could entail taking into account technologies and prepare societies for the automation age.