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 . And the tone in this blog got more and more worried as inflationary expectations gradually lost their anchor 2. 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 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.
- Is the price stability target of the ECB at risk? [↩]
- Dissecting the hawks of the ECB [↩]
- 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 [↩]
Technical post here I must say, but interesting details related to the deflation topic and that prediction about ECB.
I realize that the line between ensuring price stability and financial repression is largely philosophical. If the ends of defeating deflation justify any means, why stop with the ECB acting in the derivatives mkt? Why not adopt the Argentinian solution and have the ECB intervene in the actual publishing of inflation indices, all in the name of price stability? Where does the line need to get drawn?
I am not sure I understand the not so subtle irony. Of course the ECB should use all possible market tools to pursue its predominant objective of price stability, lower but close to 2% in the medium term, and I do not see why intervening in the derivative market should be excluded in this respect, unlike tampering with inflation data, which is utter fraud. These kind of comments do not help a cool, rational discussion of monetary policy options, being tainted by ideological overtones.
Francesco, pls don’t misunderstand me… I am not trying to introduce ideology into the discussion. I used tampering with inflation data as an extreme example.
Let me try another one. Suppose that, in the interest of maintaining price stability, the ECB decided to purchase an overwhelmingly larger amount of inflation-linked bonds as part of its LSAP facility. In fact, suppose the ECB decided to purchase only inflation-linked bonds and not nominal ones. Would you say that this is also possible? Again, where do you draw the line?
In practice purchasing only inflation protected bonds would be neither possible nor advisable, lest you have great distortion in the market plus the impossibility to have the purchases distributed all over the €-area. But of course, since the aim is to impact on inflation and inflationary expectations it makes sense to also purchase linkers. In principle, if the market for linkers was much wider and broader than what it is a concentration on these bonds would be justified.
I would draw the line between what is market intervention, and I would definitely put derivative purchases as well as purchases of linkers within this category,and non market intervention, of which your example of tampering with statistics is a fraudulent, extreme example. The choice of specific tools within the first category is a matter of opportunity, to be decided on the basis of empirical evidence. The refusal to use tools in the second category is a matter of principle.
The main problem for this unconventional tool – and in my view prohibitive for its possible success – is its complexity in the eyes of those agents that are supposed to make it effective , i.e. households and employers (cf. “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.”).
It’s not conceivable that households and firms would delve into such transactions to an extent that would render the tool any effectiveness.
Moreover, explaining this tool to the general public and to politicians is probably above the pay-grade of most central bank communicators!
I think you raise an important point. The only possible answer is that banks would intermediate the selling of inflation protection to the private sector. For instance, a bank may offer inflation protection, bought from the ECB, to a firm together with a loan or to a household together with a mortgage. I see now banks offering quite complicated investment products to their customers, while the concept of payments in case of low inflation is not so difficult. In any case the possible action on the derivative market would just be an accompanying measure, not the main tool to fight to low inflation for too long.