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Monday, 27 February 2017

Aspects of the ECB’s monetary policy: State-of-play and future prospects

Speakers: Iannis Mourmouras (Deputy Governor, Bank of Greece)
Chair: Charles Enoch (St Antony’s College, Oxford)

As the debate over ECB’s monetary policy continues, it was a pleasure to host a renowned policymaker and academic such as Iannis Mourmouras, Deputy Governor of Bank of Greece, at this joint PEFM-SEESOX event. Prof. Mourmouras drew on his experience to analyze the current targets and instruments of the ECB and offered some thoughts over the thorny question of ‘exit strategies’.

Prof. Mourmouras began his talk by discussing the track record of inflation targeting regimes over the last 15 years. Whereas they have been exceptionally successful in bringing inflation down, policymakers in Europe today face the challenge of how to push inflation back up given a persistent negative output gap. Prof. Mourmouras argues that low inflation is the symptom, not the cause of low nominal demand. The ‘suspects’ for the effect include demographic changes that lead to increased household saving, the legacy of the sudden stop and sovereign debt crisis in Southern Europe, and expectations for future low rates. Mario Draghi, the ECB president, argues further that there is insufficient investment demand to absorb all savings in the global economy.
This then leads Prof. Mourmouras to analyze the unconventional monetary policies designed to address this problem. The euro area has seen persistent low growth, nominal demand, and ultra-low inflation under 0.5% for 18 consecutive months before recently picking up. In response, the ECB embraced negative interest rates (previously extremely rare, but now increasingly adopted by central banks in the EU and beyond), expanded its balance sheet through QE programs, and introduced forward guidance. Such policies have worked slowly, but steadily, reducing cross-country heterogeneity in bank lending, flattening yield curves for sovereign yields, and providing more liquidity across the Eurozone. Inflation expectations, however, remain low for now.

Such unconventional monetary policies come with significant risks. Overall, they can lead to excessive risk-taking by lower-capitalized banks and provide a disincentive for reforms by governments. Negative interest rates additionally affect bank profitability by reducing net interest income, while some actors such as insurance and pension funds struggle to meet long-term obligations. Meanwhile, QE removes some of the safe assets required for regulatory compliance, reducing price discovery and increasing the liquidity premium. Finally, central banks across the euro area have made extensive use of ELA mechanisms under the supervision of the ECB to maintain liquidity in times of financial distress.

In addition to financial challenges, Prof. Mourmouras identified two ways in which unconventional monetary policies are also challenging central bank independence. First, the independence of central bank instruments is under pressure by external political actors that criticize governors for keeping interest rates too low depriving savers from interest income. Second, the current mix of ultra-loose monetary policy and tight fiscal policy leads the former to overcompensate to meet its own targets due to its interdependence with fiscal, financial, and structural policies. Such dominance of other policies over monetary policy challenges the mandate of independent central banks, raising questions about their accountability.

In the last part of his talk Prof. Mourmouras discussed the topical question of exit challenges going forward. He highlighted some political headwinds, such as the heightened risks of trade protectionism in light of the new US administration and the populist risk to EU’s political order posed by multiple elections in key member states. In addition, there is a high likelihood of diverging policies among the G4 central banks as the Federal Reserve awaits more certainty on US policy, the Bank of Japan prepares for QE tapering, and the Bank of England worries about higher inflation and Brexit uncertainty. Finally, financial markets remain bullish on the dollar, while more volatility and larger spread between core and periphery euro area countries could return to sovereign debt markets.

In this context, the ECB is likely to increasingly look into exit options as it worries about scarcity of safe assets and the influence of low rates on incentives for structural reform. Discussing when the ECB might increase interest rates, Prof. Mourmouras turned to the well-known ‘Taylor rule’ based on unemployment and inflation expectations. According to him, this suggests that early next year would be a rational moment for such rate increases in conjunction with the end of asset purchases. Nevertheless, he also identifies risks to premature normalization, notably the risk of relapse, financial instability around the time of the tapering, and the return of the redenomination risk.

In closing his talk, Prof. Mourmouras left the audience with some issues that needed to be addressed by exit strategies. These relate to topics such as whether assets should remain on balance sheets until maturity, what might happen to central bank independence if they sell assets on which they incur losses, and whether monetary policy tightening might be prevented from fear of financial instability. These are all issues that are surely likely to preoccupy ECB policymakers and market analysts in the months ahead.

Ivaylo Iaydjiev (St Antony’s College, Oxford)

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