Bullet points about the ECB Monetary policy

On October 1st I had a meeting with a group of investors.

To prepare for this meeting I had written down the following bullet points (as such maybe only for initiated).

Does the ECB need to ease further?

  • Repeated failure to reach the objective.
  • But some progress on inflation has been achieved.
  • Draghi argued, rightly, that employment is good (more than 11 million jobs created over 6 years; 7.5% unemployment rate).Wages more or less in line with 2% inflation (2.7 with 1% productivity growth).
  • Unfavourable external developments did not allow to move to the objective.
  • For how long can the reduction of profit margins affect the pass-through from wages to prices?
  • A new factor is the clear slowing down in activity.
  • The outlook for inflation still not satisfactory: 1.5% in 2021.
  • Draghi anxious to say that monetary policy has not exhausted its tools,
  • But he is clearly asking for help from fiscal policy.
  • Even retorting on the absence of countercyclical fiscal policy the responsibility for very short-term rates damaging (German) savers as well as aggravating the other side-effects of so expansive monetary policy for so long.
  • I cannot exclude that the ECB  may need to do even more to regain its 2.0 % objective.

How can the ECB ease further, if needed?

  • They could expand the 33% limit for purchases under QE and
  • Further reduce interest rates
  • But I have doubts about more of the same: lower rates, more QE.
  • An innovation would be to purchase bank loans, and, even more
  • To intervene on the market for Inflation derivatives.
  • Draghi has taken a cautious attitude in commenting different versions of “going direct”, including mentioning the Fischer, Hildebrand, Bartsch  proposal for temporary and central-bank-controlled “Modern Monetary Theory” like action. He has not categorically excluded them.
  • Draghi was clear on credit allocation being a fiscal issue, needing political governance.

What is your view on a review of the ECB’s monetary policy strategy?

It is very clear that the ECB is embarking on one, like the FED and the Bank of Canada, but the overall direction is not clear to me.

Still I have have a few yes coming from  a review:

  • Clarification that the inflation objective is symmetric
  • Targeting core rather than headline inflation
  • No price level targeting, but conceding something to the “make up” approach (keeping partial memory of past inflation misses)

I also have a few a few nos:

  • Adding asset prices in the target together with CPI inflation,
  • Higher target for inflation
  • Nominal GDP targeting
  • Bigger role for monetary aggregates

What will the ECB’s future operating framework look like?

  • Floor approach as far as you can look into the future. More than a decade will have to pass before the question whether to return to a balanced liquidity approach becomes relevant.
  • Probably the untold ECB desire is to get back to a balanced approach
    But this requires as precise an estimate of liquidity needs as before the crisis
  • And this is more difficult because of liquidity regulations as well as precautionary demand from banks (see current repo market difficulties in the US)

How is progress with the EMU reform agenda developing?

At Bruegel annual meeting I ventured a 70% estimate for the completion of monetary union. Vitor Constancio agreed with it.

The unfinished business is known:

  • Banking union, EDIS and completing bank resolution. The obstacle is the never ending controversy between risk reduction and risk sharing.
  • Single asset.
  • CMU, at best started.
  • European unemployment mechanism.
  • Countercyclical European fiscal policy.

All difficult dossiers, progress seems possible only under duress, but:

  • The voices calling for fiscal easing in Germany are getting louder and such action could find good cover in a European framework. Until some time ago you asked fiscal easing from Germany to help the rest of €-area, now this is asked for Germany itself.
  • Italy has partially mended its way, weakening the German-Italian blockade on progress (Italy with unsound fiscal policy, Germany with total opposition to further risk sharing)

Tiering of reserves.

  • Why parametrising to compulsory reserves and not to deposits? Maybe they did not want to give an incentive to park liquidity with the central bank or, if the basis would be fixed in the past, to reward past behaviour to keep very large amounts with the central bank.
  • Reserves are very concentrated in the core, so in a first approximation tiering helps more banks there, but the relief will be less than 4 billion (800*0.5%), not insignificant but not large either.
  • Basically the ECB is offering to banks a new 0% yielding asset for 800 billion.
  • One ECB lending tool (TLTRO) is cheaper than one absorbing tool (first tranche in deposit). Banks in the periphery, with free capacity because of deposits with the central bank lower than 6 times required reserves, could play with this.
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