A help for the ECB from the derivative market
The European Central Bank clearly has a big problem. Its dominant objective is to pursue price stability, which it defines as a rate of inflation below but close to 2.00 per cent in the medium term. It achieved this objective very well in the past, when caring that inflation would not be too high. Indeed one could even say that it did this about perfectly, once short to medium term shocks to inflation are washed out. However, since autumn of 2013, when the risk has been one of too low inflation, this blog has raised alarmed concerns about the ability of the ECB to continue complying with its objective 1) Is the price stability target of the ECB at risk? . And the tone in this blog got more and more worried as inflationary expectations gradually lost their anchor 2) Dissecting the hawks of the ECB . Finally, it became clear to us that even what we regarded as extreme monetary policy measures, like negative deposit rates and Quantitative Easing, had to be used to counter the progressive deterioration of the price stability prospects.
Chart 1 illustrates the deterioration of inflationary expectations, as derived from 2-year inflation options over the past four years. This is evident not only in the progressive move of the mode of the distribution away from the 2.00 value but also in the progressive clustering of the distribution, indicating that financial markets are hardening their expectation of inflation not complying with the ECB objective of 2.00 per cent. Worryingly, the implied probability of the most unwelcome outcomes, namely a fall in price level over a two-year horizon, has gradually increased from just above 12 per cent to almost 50 per cent as of end-2014.
Chart 1. Distribution of inflationary expectations implied in zero coupon HICP-indexed options with 2-year maturity
Source: Bloomberg ,Authors’ calculations
Now the ECB has had recourse to practically all the measures listed in this blog at the end of 2013 to further ease monetary policy, including QE. But the prospects of price stability are still not reassuring enough. Indeed, as shown in Chart 2, while the preferred ECB gauge of inflationary expectations has somewhat improved after the announcement of QE, it remains still distant from the 2.00 per cent level.
Chart 2. Expected rate of inflation in five years for the following five years.
Source: Barclays Live
The question now is whether there is something else that the European Central Bank can do to reinforce its action in the pursuit of price stability.
Here is where the somewhat exotic idea of an “off balance sheet” or “derivative based” monetary policy could help.
The idea that monetary policy could use derivative markets to pursue its objectives has appeared in the literature 3) See for instance Bindseil, Mercier, Papadia and Würtz; Challenges for the next decade of monetary policy implementation, in Mercier and Papadia, The concrete euro, Oxford University Press, 2011 but has very seldom found application. The need to find new tools for the intractable problem of unanchored inflationary expectations could now provide the incentive to test the idea in practice.
The basic idea is that the European Central Bank could offer an option in which it would pay to counterparties in the contract a certain amount of money if the inflation rate was, over a certain period, lower than a certain level, constituting the strike price of the option. Alternatively, or may be in addition, the European Central Bank could intervene in the inflation swap market, offering a fixed rate of inflation against a floating inflation.
Purchasers of the option or counterparties in the swap would make money if the rate of inflation was lower than, say, the ECB objective of 2.00 per cent over a certain period, corresponding to the “medium term” in the inflation objective. This should raise inflation prospects through a number of channels.
In the financial market, the higher inflationary expectations, coupled with cash purchases of securities under QE (or EAPP – Extended Asset Purchase Program as the ECB calls it), would lower the real rate of interest, thus favouring investment. The entry of a big seller of protection against deflation could not only change the expected value of future inflation, but also shift its entire distribution, reversing the unwelcome tendency presented in Chart 1. As a result, the probability of an extended period of deflation – as perceived by market participants – would fall, improving general sentiment and lifting “animal spirits.” In the product market, incentives to postpone purchases for consumption waiting for lower prices would be offset, since consumers could purchase the protection offered by the European Central Bank against too low inflation, thus compensating for the possibility of lower prices. In the labour market, firms could offer higher wages since they would be compensated, if inflation was too low, by the protection offered by the option or the inflation swaps entered with the ECB. Symmetrically workers would demand higher salaries (or would not accept lower salaries): in a way, it would be as if the Phillips curve had shifted up and to the right. Overall there should be a positive effect from a tool that is directly aimed at the problem: too low inflation.
There would also be “political” advantages, since the use of this tool would raise no question of a possible confusion between fiscal and monetary policy, which is indeed an issue, as there would be no obvious link between action in the derivative market and the funding of government deficits. This should be welcome to the ECB hawks, who could see the reliance of the ECB on QE being reduced. In addition, if really, if some observers foresee, the ECB would find it difficult to purchase all what it plans, it may be useful to have another tool to bring back inflation towards the level consistent with price stability. Finally, also the risk for the ECB from writing inflation options or selling protection against too low inflation in the swap market would look more favourable, in particular there would no be exposure of the ECB to sovereign default risk. Indeed the counterparty risk inherent in the derivatives positions would in general be small and manageable e.g. through collateralisation.
Of course there are also significant difficulties in launching a program of action in the derivative market. The most important one is that the ECB would have practically no precedent from which to draw information in designing and calibrating the program. Nobody has an idea of how many swap or option contracts should be signed by the ECB to have the desired effect on inflationary expectations and thus on inflation prospects. This problem, however, can be effectively dealt with by “experimenting”, making the program fully open, i.e. continuing with the action until the desired effect is reached. As it is well known the EAPP is quasi open, while what we would like to call the Derivative Market Program, or DMP, should be fully open. Of course there are also technical problems connected to the limited liquidity of the derivative market for inflation while the price the ECB should offer on its options or swaps is difficult to determine, indeed it is not even clear whether it would not be better for the ECB to offer these contracts for free, analogously to what it does while offering standing facilities. However, these are problems that should not be insurmountable for a central bank with the technical expertise of the ECB, which is not afraid of carrying out a purchase program in such a difficult market as that for Asset Backed Securities.
This post was written jointly by Juliusz Jabłecki, head of monetary policy analysis team at the National Bank of Poland (here in personal capacity) and Francesco Papadia. Madalina Norocea provided research assistance.