The ECB and Its Watchers XXI
An article by Christian Kopf
Head of Fixed-Income Fund Management and
member of the Union Investment Committee (UIC)
The main focus of this year’s The ECB and its Watchers conference was the review of the ECB’s monetary policy strategy. The broad parameters for this review were set out by ECB President Christine Lagarde in her keynote speech:
The ECB will probably abandon its currently asymmetric definition of price stability as “inflation of below, but close to, 2 per cent” and instead aim for a symmetric inflation target of 2 per cent. As Lagarde explained in her speech, the current formulation of the inflation target was appropriate when the ECB was battling excessive inflation. Inflation in the prevailing environment is too low, however, and this needs to be reflected in the inflation target.
Going forward, the ECB will take greater account of other measures of inflation, in addition to Eurostat’s Harmonised Index of Consumer Prices, and in doing so factor in the implicit cost of owner-occupied housing – a notable omission up until now.
There was broad consensus on both these points at the conference. Catalonian economist Jordi Galí put his finger on the problem: Inflation that is too low is at least as bad as inflation that is too high, so there is no justification for the downward bias in the inflation target.
There appeared to be much greater disagreement when it came to the question as to whether the ECB should follow the lead of the US Federal Reserve and take account of the very low level of past inflation in setting its monetary policy stance, as Jerome Powell explained in his keynote speech on 27 August 2020. The Fed has set itself the goal of maintaining inflation at an average of 2 per cent over the long term. Because US inflation has been below 2 per cent in recent years, the Fed is now targeting a rate of more than 2 per cent for the coming years. In adopting this form of average inflation targeting, the Fed effectively abandoned its symmetric inflation target in August 2020 and is now looking for inflation to overshoot in the near future. Christine Lagarde expressed sympathy for this approach in her speech, but Bundesbank President Jens Weidmann and the ECB’s former Chief Economist Otmar Issing reject it.
By contrast, the diagnosis that the central bank’s work is proving particularly difficult at the moment was broadly accepted. In the eurozone, the natural real interest rate (r-star), the rate at which full employment can be sustained, has fallen significantly. The central bank therefore needs to be extremely aggressive in its monetary policy interventions if it still wants to exert any influence at all – something that was acknowledged by Jens Weidmann in his speech.
It can be looked at schematically as follows: If the natural real interest rate (green line) falls from 1 per cent to minus 1 per cent, then – with an inflation target of 2 per cent – the natural nominal interest rate (grey line) will drop from 3 per cent to 1 per cent. When the economy’s capacity utilisation is high, the job of the central bank is to keep its key interest rate (blue line) above this natural interest rate in order to cool the economy and avoid overshooting its inflation target. In a downturn, however, the central bank aims to set its key interest rate below the natural nominal interest rate so as to shore up the economy and prevent inflation from slipping below the target value. If the natural interest rate continues to fall because of structural developments, then the central bank will find it harder and harder to stem the downward pressure on inflation, as it cannot keep on lowering its base rate below 0 per cent indefinitely.
The question is, what to do next. There are various proposals:
- Do nothing (unlikely). Bundesbank President Jens Weidmann merely mentioned the problem and pointed out that any adjustment to the central bank’s reaction function entailed risks.
Raise the inflation target (unlikely). Jordi Galí suggested that the central bank simply aim for a higher inflation rate if the natural real interest rate falls. This means that the natural nominal interest rate (the grey line) rises and it becomes less likely that the key interest rate offered by the central bank drops below 0 per cent during an economic downturn. In a recent working paper, Galí argues that the optimal inflation rate rises by 0.9 per cent when the natural interest rate falls by 1 per cent.
This proposal of simply raising the inflation target was put forward by Olivier Blanchard many years ago. As well as encountering political resistance in countries like Germany, however, the ECB would not really increase its credibility if it raised its inflation target to 3 per cent when for years it has undershot its current inflation target of below, but close to, 2.0 per cent. Galí also concedes this.
Further reduce the deposit rate (unlikely). There is consensus that negative deposit rates can depress the profitability of commercial banks, thereby running contrary to the aim of facilitating lending (Markus Brunnermeier’s reversal interest rate argument). However, it remains unclear at which interest rate these negative effects predominate, and some central bankers have previously suggested to test this by reducing the deposit rate to minus 1 per cent or so, if needed. This, however, does not sit well with other members of the ECB Governing Council. At present, I can see the deposit rate being lowered further only in order to fend off a significant appreciation of the euro.
Further reduce the TLTRO rate (likely). Although the ECB cannot really reduce its deposit rate any lower than the current level of minus 0.5 per cent, due to concerns about the profitability of banks, it can further reduce the interest rate at which it conducts targeted longer-term refinancing operations (TLTROs) with commercial banks, which currently stands at minus 1 per cent. This dual interest rate system, consisting of a stable negative deposit rate and a variable negative TLTRO rate, is viewed by some observers as the “ECB’s new silver bullet”.
At the current interest rate, the TLTROs act as a subsidy for the banks: They can borrow fixed-term deposits from the ECB at minus 1 per cent, and then use this money to finance loans to their customers at higher interest rates or even invest it in the ECB’s deposit facility at minus 0.5 per cent and generate a risk-free return. The ECB of course hopes that the increased profitability of the commercial banks resulting from this practice will prompt them to increase their lending.
Expand asset purchases (likely). Stepping up bond purchases (quantitative easing) could also weigh on the commercial banks’ profitability due to the flattening of the yield curve. In the euro area, however, a large portion of central banks’ asset purchases consist of government bonds from the so-called “periphery” and of corporate bonds. To the extent that these purchases result in a decline in market risk premia, they should boost the banks’ profitability and thereby shore up both the economy and inflation. Lucrezia Reichlin, an economist from the London Business School, who spoke at our risk management conference last year, showed that bond purchases – which are no longer ‘unconventional’ and have long been part of central banks’ standard repertoire of monetary policy instruments – have little impact on the real economy. Nevertheless, if inflation does not pick up soon in the eurozone (which is improbably in the short term), the ECB will likely expand the term and/or scope of its pandemic emergency purchase programme (PEPP) in December.
This brings me to my personal conclusions:
The ECB will probably leave its deposit rate at minus 0.5 per cent for a very long time. It is also likely to expand its purchase programme in December and possibly also lower the TLTRO rate. This would support the credit ratings of corporate and bank bonds.
At the same time, inflation is likely to start rising slowly in 2021 as the economy recovers from the shock of the pandemic. This means that real interest rates will fall as nominal interest rates are held steady. The ECB will therefore pursue a procyclical approach to monetary policy for the foreseeable future, which is extremely good news for the equity markets.
As at 7 October 2020