Question

Outline and evaluate the current framework for setting monetary policy in the Eurozone

Answer 1

The current framework for setting monetary policy in the Eurozone:

The current framework:

• The primary mandate of the ECB, as laid out in Article 127.1 of the Treaty on the Functioning of the European Union (TFEU), is to ensure price stability in the euro area and, without prejudice to this objective, to support the general economic policies of the Union. To fulfil its primary mandate, the ECB Governing Council adopted in 1998 the following quantitative definition of price stability: “price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%”.
• In 2003, the Governing Council clarified that in the pursuit of price stability it aims to “maintain inflation rates below, but close to, 2% over the medium term”. The ECB’s main instruments until the crisis were its three short-term policy interest rates (the main refinancing operation rate, the deposit rate and the marginal lending rate), with which it sought to control short-term market rates (the Euro OverNight Index Average, EONIA) and ultimately to influence the rest of the yield curve. But when short-term rates reach the zero lower bound, central banks need to rely on unconventional tools to affect directly the medium and long-term parts of the yield curve.
• Central banks have developed a diverse array of tools to do that: forward guidance (i.e. communication about the likely future course of monetary policy), negative policy rates and, most importantly, changes in the size, composition and maturity of their balance sheets, mainly through asset purchases and massive longterm refinancing operations.
• Since 2008, the ECB has gradually applied all of these policies. First, it reduced its policy rates, and now, at -0.4 percent, its deposit rate is in slightly negative territory. The ECB also very quickly provided longterm lending to European banks with favourable conditions through long-term refinancing operations and targeted longer-term refinancing operations.
• Since 2013, the ECB has provided forward guidance on the future path of its policy interest rates. Finally, the ECB has put in place a diversified asset purchases programme that originally included asset-backed securities and covered bonds, but which was vastly expanded in 2015 with the inclusion of sovereign and European supranational bonds and, later, of corporate and local government bonds.

Is the current framework suitable to face new challenges and an increase in uncertainty?

• The ECB framework has proved flexible (even if it sometimes adjusted more slowly than in other jurisdictions during the crisis) and, as discussed in section 3.1, its toolbox expanded greatly during the crisis. A lower neutral rate implies that episodes in which monetary policy is constrained by the effective lower bound are likely to be more frequent and longer.
• This implies that the ECB would need to rely more heavily on these unconventional tools. However, our understanding of the effects of asset purchases, for example, is not complete. A growing body of empirical literature (see for instance Weale and Wieladek, 2016; Meinusch and Tillmann, 2016; ECB 2017) concludes that quantitative-easing (QE) programmes implemented around the world have boosted inflation, output and employment. However, given their relative novelty, it is more difficult to measure the impact of asset purchases, and the purchases themselves have been more difficult to calibrate than conventional interest rate cuts. More importantly, given the particular institutional arrangement of EMU (as discussed in section 2.4), the use of these policies has been politically controversial in some countries, which delayed their implementation in the euro area.
• As a result, the ECB’s quantitative easing programme started six years after the beginning of asset purchases by the Fed and the Bank of England. And if the fall in the neutral rate implies a need for more frequent and decisive use of such unconventional tools, such a reluctance to use them might lead to permanent suboptimal monetary outcomes in the euro area.
• At the same time, the self-imposed constraints put in place by the ECB Governing Council when it created its sovereign asset purchase programme in 2015 could reduce drastically the scope of asset purchases in the future. The ECB Governing Council decided to put in place a 25 percent issue limit and a 33 percent issuer limit on Eurosystem holdings for its sovereign asset purchases. The 25 percent issue limit in particular was imposed to prevent the ECB from having “a blocking minority in a debt restructuring involving collective action clauses” (ECB, 2015).
• This indicated that the ECB did not wish to be in a position in which it had the power to block a potential vote on the restructuring of a euro-area country’s ECB-held debt, because not blocking such a restructuring could be interpreted as monetary financing of a member state. On the contrary, if a majority of creditors with collective action clauses would accept a restructuring of some bonds, the ECB could do nothing against such a restructuring and would have to accept it.
• In that case, this would not be seen as monetary financing and would therefore not be in contradiction to the EU Treaty. In September 2015, the issue share limit was increased from 25 percent to 33 percent for debt securities not containing collective action clauses, to increase the maximum amount that the Eurosystem can hold of a particular issue.
• This allowed the Public Sector Purchase Programme to continue for longer than was originally possible under the previous rules. However, given the massive purchases between March 2015 and the end of 2018, if QE had to be activated again, this rule would limit drastically the possible purchases because the holdings of bonds of major countries are already approaching the 33 percent limit.
• Naturally, one solution would be for the ECB to relax this rule, a risk that it appears at the time of writing unwilling to take. One could consider however, whether the current limits achieve the right balance between running the risk of monetary financing against the risk of the ECB not meeting its price stability objective.
• For instance, the risk of monetary financing of an AAA-rated government such as Germany or the Netherlands appears to be currently negligible and should not act as a constraint on the implementation of the asset purchase programme and the fulfilment of the ECB’s mandate. In order to facilitate the implementation of its QE programme, should it need to use it again, the ECB should thus waive the 25 percent limit, at least for well-rated countries. However, the mere existence of this rule indicates clearly that the ECB remains uneasy about the idea of purchasing the sovereign bonds of member states, and that some members of the Governing Council do not yet consider QE a conventional tool that should be used as much as necessary.
• Another way to reduce long-term yields without buying too many bonds could be to put in place a ‘yield curve control’ policy, similar to that currently implemented in Japan (BoJ, 2016). If this type of policy is deemed credible by markets, the reduction of long-term interest rates could be obtained with fewer asset purchases than with a simple QE programme. However, it would be very difficult to put in place this type of policy in the euro area given that using such a strategy, which would lead to announcing a target level of interest rate for a given country, would not be compatible with maintaining the pretence of market discipline over the public finances of member states. As far as negative rates as concerned, next time it is needed to relax the ECB’s monetary policy stance, the ECB could try to go deeper into negative territory than it has so far (at time of writing the deposit rate is fixed at -0.4 percent).
• However, recent data released by the ECB (2018) shows that cash hoarding by banks has increased significantly as a result of negative deposit rates – even if the sums at stake are still marginal compared to the overall amount of excess reserves. This suggests that the ECB might have already reached its effective lower bound and that it might be difficult to go below that in the future (especially if banks have already built up the capacity to store cash in order to avoid the negative deposit rate).
• Also, the potential side-effects on bank profitability and lending capacity could reduce such an instrument’s effectiveness in terms of stimulating growth and inflation in a bank-based financial system (even if this argument might be overstated, as shown by Demertzis and Wolff, 2016, on the evidence so far). Potential solutions to these problems include taxing paper currency (as suggested in Agarwal and Kimball, 2015; or Kimball, 2015) or abolishing it altogether (Rogoff, 2016).
• But these solutions might be too extreme and, most importantly, highly unpopular in some member states. Overall, we believe that the addition of asset purchases and negative rates to the ECB’s toolbox was absolutely necessary and helped to fight deflationary pressures in the euro area. However, given the limits of these instruments they might not be sufficient in the next crisis. What else can be done? All major central banks in advanced economies set an implicit or explicit numerical goal in terms of inflation, and employ the tools at their disposal accordingly. However, the difficulties experienced in reaching the inflation target have strengthened the case of those advocating a revision of the framework used by central banks, or, at least, their tools. We explore this in the next section.