Or, as shown by Nelson et al (2015), a monetary tightening can also cause a migration of activity from the regulated banking sector to the shadow-banking sector. With the help of simulations, Demertzis and Viegi (2010) demonstrated how important it is for the target to be clear (no noise), for bands to be defined and for an appropriate width of the bands to be chosen. This discussion received an important impetus after the then Fed Chair Janet Yellen acknowledged it was a relevant issue in one of her last press conferences (Yellen, 2017). A strong fall in the neutral rate would reduce significantly central banks’ margin for manoeuvre. We argue that, as a result, central banks will have to put in place a systematic approach to managing uncertainty. In order to illustrate the point, the average reduction in the policy rate during recessions since the 1950s was around 500 basis points in the US, and a bit less than 300 basis points in the UK and in Germany (see Table 1). It is true that consumers are affected by all prices included in the headline HICP basket, not just core prices. La politique monétaire de la BCE a été fondée, comme par le passé, sur deux piliers. However, the decline in real rates could also be due to transitory factors. The Fed is about to conclude a review of its framework and the review of the ECB’s monetary policy strategy has been implicitly announced. Following in the footsteps of the U.S. Federal Reserve, the European Central Bank (ECB) has launched an in-depth review of its monetary policy strategy. The primary objective of the ECB’s monetary policy is to maintain price stability. An increase in capital inflows because of higher interest rates can partially offset the dampening effect of higher rates on credit. Far from diminishing the role of communication, we believe that uncertain times require a lot of information about what types of ‘insurance’ we put in place to deal with many different types of ‘unknowns’. We discuss how the ECB should deal with this issue in section 4.2. Faced with a rising household debt-to-income ratio, the Riksbank increased its policy rate from 0.25 percent in July 2010 to 2 percent in July 2011. In its policy statement, the ECB said it was maintaining the eurozone deposit rate at -0.50%, the refinancing rate at 0%, and the marginal lending facility rate at 0.25%. A further problem in targeting financial stability with monetary tools is that monetary policy tightening might not actually have the desired effect of reducing financial imbalances. A very clear example of this could be to include an analysis of the distributional impacts of their policies in the regular publications that all central banks provide (eg for the ECB in its economic bulletin). Drehmann et al (2012) argued that this could often be the case given that financial cycles are much longer than traditional business cycles. In our view, monetary policy should not target financial stability. In addition to these macroeconomic and financial challenges faced by central banks all around the world, the ECB has to meet another important challenge: the euro-area economic governance framework is incomplete and inadequate to face shocks, and is – by construction – heavily fragmented between national authorities and centralised institutions. ECB’s mandate, policy strategy and the operational framework The European Central Bank (ECB) was established on 1 June 1998 and assumed responsibility for setting monetary policy for the euro area on 1 January 1999. 13 March 2020. On 2 August 2012, the Governing Council of the European Central Bank (ECB) announced that it would undertake outright transactions in secondary, sovereign bond markets, aimed "at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy". To this end, we recommend that the ECB adapts its monetary policy framework in order to manage uncertainty by providing clarity where it is possible and maintain flexibility when and where it is needed, as follows: 2.1 A potential decline of neutral interest rates. of 7 April 2020. amending Guideline (EU) 2015/510 on the implementation of the Eurosystem monetary policy framework and Guideline (EU) 2016/65 on the valuation haircuts applied in the implementation of the Eurosystem monetary policy framework (ECB/2020/20) Closer coordination with national macroprudential authorities and greater harmonisation in the use of macroprudential policies are however strongly recommended, as it is now acknowledged that financial and monetary policies are closely interlinked. But these solutions might be too extreme and, most importantly, highly unpopular in some member states. The ECB’s limited remit might well be the weakness of the institutional arrangement, but the practice of macro-prudential policies will show if this limitation is severe or if cooperation between the ECB and national authorities, under the watch of the European Systemic Risk Board, ensures the proper implementation of the various macroprudential tools. And it is a more robust method because it avoids very distortionary outcomes more effectively. Central banks need therefore to design policies that will be effective for a variety of different outcomes. One option would be to align it with the length of the business cycle. Wolff (2017) provided an example of the need to understand the different forms of slack for the German economy. 1 Article 127.1 of the Treaty on the Functioning of the European Union (TFEU). When the ECB carried out its previous policy review in 2003 “one of the key assumptions was that the natural rate of interest hovered around 2%, and that’s not the case anymore. First, fiscal policy in the monetary union is much more constrained than outside of it because the risk of default is higher given the prohibition of monetary financing. Journal of Macroeconomics (Topics) 9(1), Demertzis, Maria, and Guntram B. Wolff (2016) ‘What impact does the ECB’s quantitative easing policy have on bank profitability?’ Policy Contribution 2016/20, Bruegel, Drehmann, Mathias, Claudio Borio and Kostas Tsatsaronis (2012) ‘Characterising the financial cycle: don’t lose sight of the medium term!’ BIS Working Papers 380, Bank for International Settlements, Ducrozet, Frederik (2016) ‘Bond scarcity under new ECB QE rules – It Ain’t Over Till It’s Over’, Pictet Wealth Management Flash Notes, 14 December, available at https://perspectives.pictet.com/wp-content/uploads/2016/12/Flash-Note-FD-ECB-QE-bond-scarcity-14-December-2016-1.pdf, ECB (2015) Implementation aspects of the public sector purchase programme (PSPP), 5 March, European Central Bank, available at http://www.ecb.europa.eu/mopo/liq/html/pspp.en.html, ECB (2017) Decision 2015/774 of the ECB of 4 March 2015 on a secondary markets public sector asset purchase programme (ECB/2015/10) amended in 2015, 2016 and 2017, European Central Bank, available at https://www.ecb.europa.eu/ecb/legal/pdf/celex_02015d0010-20170113_en_txt.pdf, ECB (2017) ‘Impact of the ECB’s non-standard measures on financing conditions: taking stock of recent evidence’, Economic Bulletin, Issue 2, ECB (2018) ‘The cash holdings of monetary financial institutions in the euro area’, in Laure Lalouette and Henk Esselink, Trends and developments in the use of euro cash over the past ten years, European Central Bank, available at https://www.ecb.europa.eu/pub/economic-bulletin/articles/2018/html/ecb.ebart201806_03.en.html#toc6, El-Erian, Mohamed (2017) The only Game in Town: Central Banks, Instability and Avoiding the Next Collapse, Random House, New York, Eggertson, Gauti B., and Neil R. Mehrotra (2014) ‘A Model of Secular Stagnation’, NBER Working Paper No. However, we do not believe that a financial stability objective should be included in the welfare function of monetary policy, because that would jeopardise the ability to pursue price stability. This subsequently was amended in 2002, while Issing still served at the ECB, to include the words ‘below, but close to, 2%’. Price stability could be defined as inflation around 2 percent “on average” over, say, the business cycle5. In times of structural uncertainty however, communication becomes harder and possibly less effective. Read about the ECB’s monetary policy instruments and see the latest data on its open market operations. “The usefulness of such an approach could be examined,” she said. The ECB framework has proved flexible (even if it sometimes adjusted more slowly than in other jurisdictions during the crisis) and, as discussed in section 3.1, its toolbox expanded greatly during the crisis. us, Challenges for monetary policy in the euro area, Adapting the ECB’s framework to face these challenges. The problematic interaction between nineteen different fiscal policies and a common monetary policy, the lack of a stabilisation tool and differences in national macro-prudential frameworks would all suggest significant reforms are needed in these realms to strengthen the overall resilience of the system. As strongly emphasised by the German Council of Economic Experts (2015), a lot of uncertainty surrounds these neutral rate estimates, and the confidence intervals reported in the literature are generally very large. More importantly, given the particular institutional arrangement of EMU (as discussed in section 2.4), the use of these policies has been politically controversial in some countries, which delayed their implementation in the euro area. This implied that in the long run the Phillips curve was vertical. Monetary policy has to navigate without full knowledge of what the post-crisis ‘new normal’ is going to be. Agur and Demertzis (2018), for instance, showed that the effect of monetary policy on financial stability varies in direction depending on the part of the financial cycle the economy is at. However, our policy recommendations do not depart drastically from the current framework, in recognition of the fact that radical change is not needed and that a total overhaul might jeopardise the long-earned credibility that the ECB has acquired over the last 20 years. Second, the potential flattening of the Phillips curve (ie the weakening of the relationship between inflation and unemployment) in recent decades could reduce the ability of central banks to reach their inflation targets. It might very well be that the large imbalances that developed in the early 2000s no longer pose an immediate threat, and that the financial system is better and more tightly regulated. Second, the period over which price stability is measured should be lengthened to increase flexibility. All major central banks in advanced economies set an implicit or explicit numerical goal in terms of inflation, and employ the tools at their disposal accordingly. So, Patricia, allow me to thank you warmly for organising this lecture on the ECB’s monetary policy and the resilience of the Eurozone. Disclaimer The review will consider whether the ECB’s inflation aim should be reformulated and over which time horizon prices should be stabilised, among other questions. However, given the limits of these instruments they might not be sufficient in the next crisis. On 13 October 1998, the ECB Governing Council agreed on the main elements of its monetary policy strategy, namely (i) a quantitative definition of price stability, (ii) an important role for the monitoring of the money growth identified by a monetary aggregate and (iii) a broadly based assessment of the outlook for price developments. These are important ingredients in improving the clarity of the current definition of price stability. Transformation of the Chinese economic model and the fall in the oil price have already resulted in a reduction in emerging markets’ excess savings. The implications of evolving policy regimes’, BIS Working Paper No. LONDON — Following in the footsteps of the US Federal Reserve, the European Central Bank (ECB) has launched an in-depth review of its monetary-policy strategy. We have argued that altering the ECB’s definition of price stability might be a crucial part of providing such flexibility. On 1 May 2018, the ECB celebrated its 20th anniversary. The burgeoning literature discussing this important issue (see for instance Constâncio, 2017, or Carney, 2017), has proposed three main explanations: 1) the NAIRU might be more sensitive than thought to the macroeconomic cycle; 2) an increased monopsony power of employers combined with a general fall in the bargaining power of employees is keeping wage growth low; and finally 3) low productivity growth might also explain why wages have failed to catch up with the economic recovery. It is not obvious why there needs to be room for interpretation at the level of defining the inflation objective. Rehn told Central Banking that he would like the ECB to replace its. Finally, we present the ECB’s framework for thinking about non-standard monetary policy measures and review the evidence on their effectiveness. This rate is defined as the equilibrium rate between demand and supply of funds compatible with full employment of capital and labour resources, and with price stability (ie inflation around the central bank’s target). This would lead to lower real rates during recessions and would thus increase the policy space. However, although the Riksbank initially aimed to ward off the threat to financial stability from household over-indebtedness, the household debt-to-income ratio was not affected by the 2010-11 policy of tightening and in fact the ratio continued to increase in real terms because of the very low and even negative inflation rates. We therefore argue that it is important to find ways for monetary policy (and indeed other policies) to manage uncertainty systematically. Look at press releases, speeches and interviews and filter them by date, speaker or activity. That is why we need to come back to the issue of what needs to be done if there is a substantial divergence between the price stability objective and the financial stability objective. Launch. This set forms the operational framework to implement the single monetary policy (see instruments). Even if the framework has improved in recent years, there is a good chance that the ECB will have to step in once again from a stabilisation perspective. To summarise, the various issues we have reviewed show that the main monetary policy instrument, the interest rate, is too broad and too blunt, and is ultimately quite ineffective in dealing with the build-up of financial imbalances. The ECB's monetary policy framework however does not envisage any mechanistic reaction to fiscal policy changes. Overview. While it remains unclear what the post-crisis ‘new normal’ will be, three new features will characterise monetary policy in the euro area in the short-to-medium term: large central-bank balance sheets, persistently low and close to zero interest rates, and a potential weakening of the transmission mechanism through which the central bank can affect aggregate demand. The natural next step to the logic is that if one were to aim to achieve something higher than 2 percent – say 4 percent as Blanchard et al argue – within the two-year horizon, it would help achieve 2 percent on average over the longer run. Capital inflows and/or currency appreciation could accentuate the shift from the tradable to the non-tradable sector that often takes place when there is a real-estate boom. Powell said the Fed aimed to achieve an average inflation level of 2% “over time” and allow inflation to “moderately overshoot” its target after periods when inflation was below its 2% goal. The guidelines also clarify the application process and acceptance criteria for external credit assessment institutions in the Eurosystem credit assessment framework. In light of these considerations, we recommend that the ECB should update its definition of price stability to target core inflation around two percent per year (allowing a tolerance band on either side of the two percent target), on average, over a longer time horizon. This would give less leeway to cut rates when the next recession arrives. Figure 4: Core and HICP inflation rates in the euro area (1999-2018). Operating framework; Decisions; Communication; Unconventional; International; ECB set to boost QE purchases and extend duration of stimulus. The 25 percent issue limit in particular was imposed to prevent the ECB from having “a blocking minority in a debt restructuring involving collective action clauses” (ECB, 2015). The ECB’s monetary policy strategy. On the contrary, if a majority of creditors with collective action clauses would accept a restructuring of some bonds, the ECB could do nothing against such a restructuring and would have to accept it. However, uncertainties about the real drivers of productivity, ranging from the possible reversal of globalisation to the role of disruptive digital technologies, all contribute to our inability to estimate precisely the neutral rate of interest. We would therefore not exclude exploring the possibility of using instruments that have not been used during the crisis: for instance, helicopter money (ie direct injections of cash into the economy by the central bank) or targeted longer-term refinancing operations with negative rates below the deposit rate. In May 2003, following a thorough review of the ECB's monetary policy strategy, the Governing Council clarified that “in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term”. However, the probability of seeing material changes before the next recession is relatively low, thus presumably leaving the European Central Bank’s pivotal role unchanged. In this respect policies, as we have argued in this paper, need to be chosen not just to address very specific circumstances, but to take account of many different possible outcomes. And if the fall in the neutral rate implies a need for more frequent and decisive use of such unconventional tools, such a reluctance to use them might lead to permanent suboptimal monetary outcomes in the euro area. The first problem for the ECB is that the euro area’s current macroeconomic policy framework is not able to provide enough stabilisation in deep downturns and ends up relying on the ECB as a result (Claeys, 2017). However, Friedman’s famous criticism of the Phillips curve (Friedman, 1968) asserted that monetary policy could not sustain unemployment below its “natural rate” (determined by structural factors) without leading to accelerating inflation (that is why the natural rate of unemployment is now often referred to as the non-accelerating inflation rate of unemployment or NAIRU). However, while inflation might have been the most important factor behind this trend from 1980 to the end of the 1990s, most of the decline since 2000 has been the result of the fall in long-term real safe rates at the global level. The global financial crisis reignited an earlier debate (Borio and White, 2004; Rajan, 2006) about whether monetary policy should target financial stability. This means that the definition could be changed again by the ECB if necessary. Moreover, in the case of a monetary union like the euro area, a “leaning against the wind” monetary policy could be even more difficult to put in place because financial cycles in different countries are not necessarily synchronised (Merler, 2015). Reproduction is permitted provided that the source is acknowledged. Potential solutions to these problems include taxing paper currency (as suggested in Agarwal and Kimball, 2015; or Kimball, 2015) or abolishing it altogether (Rogoff, 2016). However, it would be very difficult to put in place this type of policy in the euro area given that using such a strategy, which would lead to announcing a target level of interest rate for a given country, would not be compatible with maintaining the pretence of market discipline over the public finances of member states. In addition, our suggestion about the change to the definition of price stability would be less radical than other proposals. 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