European Central Bank Moves Gradually Toward More Unconventional Policy

David Mackie, JP Morgan, London.
This article appeared in the April 2009 issue of Current Economics with permission of the author.

Key Concepts: Unconventional Monetary Policy | Quantitative Easing |
Key Economies: Euro zone |

The European Central Bank (ECB) took a step toward more unconventional monetary policy at its March meeting, in two respects: first, it cut the policy rate to 1.5% and signalled that the trough is near; and second, it slashed its growth forecast, making it more likely that conventional monetary policy will not be enough to ensure price stability in the medium term.

We have made three observations regarding the ECB and unconventional monetary policy in recent months: first, legally and technically, the ECB has as much room to maneuver as any other central bank; second, its reluctance thus far has been partly because it has not believed that such policy is needed, and partly because of the risks created for future moral hazard and inflation; and third, in a relative sense, the ECB will never do as much as the US Federal Reserve.

The press statement and Q&A which followed the meeting did not challenge these views. In response to a question about the ECB’s options, President Trichet explicitly said: “Our hands are not tied; I am ruling nothing out.” He said that the central bank is discussing both if there is a need for more unconventional policy and exactly how it might work in the Euro area. Whether or not the central bank does more unconventional policy than it has already done remains to be seen; presumably the decision will be driven by developments in the economy and financial markets and by the outcome of the central bank’s own analysis. If the recession drags on through to the end of this year, and core inflation falls sharply, then the ECB is likely to engage in more unconventional policy, albeit in a limited manner. This is our central projection. Only if the macro and financial landscape turns out to be significantly more troubling than our central forecast assumes is the ECB likely to do anything more aggressive.

Volume of ECB liquidity operations
€bn, total volume of liquidity supplied in euros
Change in ECB balance sheet since September
ECB liquidity operations ECB balance sheet

A Taxonomy of Unconventional Policy

Central banks are the monopoly suppliers of base money (bank notes and commercial bank reserves with the central bank) and can thus determine either the price or the quantity supplied. Conventional monetary policy involves the central bank’s setting the price of base money (or at least the commercial bank reserves part of it). Unconventional monetary policy refers to the expansion of base money (or at least the commercial bank reserves part of it). In order to expand commercial bank reserves, central banks purchase assets from the private sector (banks and other investors). These assets can be either public or private, new or existing, and the operations can occur on a repo or outright basis.

It is probably helpful to distinguish between a micro motivation for unconventional policy and a macro motivation. Following the Lehman’s bankruptcy, the ECB provided more commercial bank reserves than were needed to keep the overnight rate in line with its target — and also extended the duration of liquidity provision and expanded the pool of eligible collateral — in order to mitigate the consequences of a decline in interbank activity. The fall in the actual overnight rate was limited by the marginal deposit facility rate which determines the interest rate paid on excess reserves. This provision of additional bank reserves was driven by microeconomic considerations; addressing problems with the plumbing of the credit system. This kind of unconventional monetary policy can be undertaken at any level of the policy rate, owing to the payment of interest on reserves.

Factors affecting lending standards for corporate loans
%, net percentage of banks reporting a contribution to tighter standards
Euro area M3 and household and nonfinancial corporate loans
% over year ago
Lending standards for corporate loans M3 and household loans in the euro area

The more macro motivation for unconventional monetary policy relates to the situation where the policy rate has reached the lower bound (which may or may not be zero). In this circumstance, the central bank may conclude that conventional monetary policy alone will not be sufficient to achieve its inflation objective. A move to unconventional monetary policy provides the means for additional monetary stimulus.

How Unconventional Policy Works

Perhaps the best way to explain how unconventional monetary policy is supposed to work is to consider how conventional monetary policy works. Conventional monetary policy affects the economy through both the demand for and supply of credit. The demand for credit is influenced by borrowing costs, the business cycle (labor market conditions), and asset prices (wealth effects); while the supply of credit is influenced by the condition of bank balance sheets (liquidity, funding, and capital), the business cycle (default risk), and asset prices (collateral valuation). A change in the price of commercial bank reserves influences a broad range of borrowing costs and asset prices, as expectations are affected and as financial market participants seek to optimize their portfolios. These changes influence cash flows, perceptions of wealth, balance sheet health, and intertemporal substitution. These developments then affect the business cycle and a cumulative upswing or downswing begins.

Credit growth has pretty much stagnated in the euro area in recent months, as both the demand for and supply of credit have declined. Households and corporates are demanding less credit because of the business cycle downturn and the collapse in wealth. Banks are supplying less credit because of funding difficulties, capital constraints, and concern about default risk and the valuation of collateral. Against this backdrop, unconventional monetary policy, along with other public sector support for the banking system, can be thought to help the credit creation process in a couple of important ways. First, to the extent that central bank purchases reduce borrowing costs and lift asset prices, this may increase both the demand for and supply of credit by increasing cash flows, perceptions of wealth, balance sheet health, and intertemporal substitution. And second, to the extent that banks want to maintain a particular ratio between central bank reserves and their assets, they may respond to the increase in their reserves with the central bank by expanding their balance sheets. Once the central bank has increased the amount of commercial bank reserves in the system, banks cannot eliminate these reserves. They can, however, expand their balance sheets (the money multiplier) which will affect the ratio of reserves to the size of their total assets.

ECB balance sheet
ECB balance sheet

In addition to these two channels, which work through the banking system, central banks can provide credit directly to the non-financial private sector. The US Fed’s CP (commercial paper) and TALF (term asset-backed securities loan facility) programs are examples of this. But, in the absence of a large securitization market, which underpins the TALF in the US, this is likely to be a limited channel for unconventional policy. The ECB could lend to large corporates via a CP program, but it would be hard to use this mechanism to extend credit directly to small companies and households. Given the financial structure of the Euro area, it seems likely that any unconventional policy will work largely through the banking system. To the extent that the ECB purchases private-sector assets, improved conditions in such markets might indirectly help new issuance.

Another channel for unconventional monetary policy, which is not being discussed much at the moment by central bankers but is a huge part of the academic literature, is the direct impact on inflation expectations. The implication of this literature is that by committing to a significantly higher inflation objective for a sustained period, central banks can shift private sector inflation expectations higher. Indeed, this point was made forcefully by Bernanke (Chairman of the US Federal Reserve) in a speech in 2002: “The US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services.” It is not clear how significant this channel is expected to be in the current environment.

Some commentators make a distinction between central bank purchases of government debt against the backdrop of an unchanged fiscal stance — which simply replaces government debt on private sector balance sheets with base money — and central bank purchases of government debt against the backdrop of fiscal easing — which is often referred to as a helicopter drop. It is unclear how important this distinction is: the effect of a helicopter drop will depend on how households and corporates respond to what would be a temporary increase in their holdings of base money. Even more obviously than with bond-financed fiscal easing, a money-financed fiscal easing would need to be reversed in order to prevent inflation from eroding the value of the money created.

Will Unconventional Policy be Needed?

Following the Lehman’s bankruptcy, the ECB engaged in micro-oriented unconventional policy: between early September and early October last year, commercial bank reserves expanded 83% even as the policy rate remained at 4.25% (base money overall increased 21%). This was achieved by the central bank expanding its normal repo operations with banks.

Monthly flow of new loans to the non-bank private sector
€bn, seasonally adjusted, data are adjusted for impact of loan sales and securitizations
New bank loans

A decision to engage in more macro-oriented unconventional monetary policy will depend on whether the ECB considers that such policy is warranted by the macro outlook and whether the benefits of trying to move inflation back to the central bank’s definition of price stability more quickly than would otherwise occur outweighs the risks associated with such policy. Exactly what the ECB will decide remains unclear; the message from the March meeting was mixed.

The dramatic change in the ECB’s forecast raises the likelihood that the central bank will conclude at some point that conventional monetary policy will not be sufficient to ensure price stability in the medium term. The ECB forecast published in early December appeared optimistic at the time and was quickly overtaken by events. What is striking about what the ECB did in March is that it leapfrogged over the consensus and delivered a particularly gloomy assessment of the growth outlook. Regarding this year for example, the ECB moved its growth forecast from -0.5% in December to -2.7% now. During this period, the consensus forecast moved from -0.9% to -2.6%. We are sympathetic to what the ECB has done. Indeed, we recently decided to shave off a percentage point from our growth forecast for the next three quarters, which puts our annual number for this year at -3.2%. The other pressure toward more unconventional monetary policy is the stagnation in credit growth in the region. The ECB has long abandoned the idea of a numerical objective for money growth, but it is hard to see how stagnant credit growth is consistent with the ECB’s definition of price stability. The message regarding whether unconventional policy is warranted didn’t go only one way at the recent meeting: President Trichet downplayed the risk of deflation and he argued that conventional monetary policy is getting good traction.

Even if the ECB concludes that conventional monetary policy will be insufficient to move inflation back to the central bank’s definition of price stability in the medium term, it could still resist further balance sheet expansion, owing to doubts about the efficacy of unconventional policy and concern about the risks of future moral hazard and inflation associated with such policy. There are alternatives to further balance sheet expansion. The ECB could extend the horizon over which it wants to achieve price stability. In Sweden and Norway, inflation fell to levels significantly below the central bank targets in the early years of this decade, but neither the Riksbank nor the Norges Bank engaged in balance sheet expansion; they simply extended the horizon over which they expected to hit their inflation targets. Moreover, the commitment to maintaining the current system of a full allotment of fixed rate repos until at least the end of this year can be viewed as an alternative to further balance sheet expansion.

Quarterly trajectory for growth in the Euro area
%q/q, saar for quarterly breakdowns, %oya for annual averages
Euro zone growth forecast

Unconventional Policy Implementation

Some commentators are concerned that, even if it wanted to engage in aggressive quantitative easing, the ECB would have less scope than other central banks, because of the absence of a centralized government in the Euro area, a legal prohibition on the ECB’s funding of government deficits, and a “no bailout” approach that prevents the ECB, other governments, or European Commission institutions from bailing out an individual government that gets into trouble. However, we do not believe that these restrictions would effectively constrain the ECB from conducting whatever policy was considered appropriate. The Maastricht Treaty protects the ECB’s autonomy and independence, while giving the central bank the freedom to conduct policy as it feels is appropriate. Thus, what the ECB will do regarding further unconventional monetary policy will depend on its assessment of the benefits and risks of adopting various measures to expand its balance sheet, rather than on any perceived constraints.

It is not clear what further unconventional policy would look like in the Euro area. In the US, the Fed has focused on reducing borrowing rates in the mortgage market by outright purchases of mortgage-backed securities and on the provision of new credit to non-banks via the CP program and TALF. By focusing on private sector assets as the counterpart to the creation of base money, these actions involve some credit risk exposure, which has been underpinned by the Treasury. In contrast, the Bank of England has focused more on the creation of base money through purchases of government debt, with the aim of reducing risk-free rates of return and making private sector balance sheets more liquid. The credit risk associated with the Bank of England’s actions is more limited. Given both the dominance of the banking sector in the Euro area, and the absence of a single fiscal authority to offload credit risk onto, the behavior of the ECB is more likely to resemble that of the Bank of England rather than that of the Fed. Regarding amounts, we would expect the ECB to move cautiously relative to the Fed and the Bank of England. In its announcement in March, for example, the Bank of England committed to increasing commercial bank reserves 240% (and base money 98%). We would expect the ECB to do less than this, at least to start with.

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