UNIQA Capital Markets Weekly

The strategic review of the ECB: Disappointing the critics

• From “below but close” to a symmetric inflation target implies low-for-longer.
• QE works and is part of the toolkit but negative side effects must be part of the central bank’s economic analysis.
• Contrary to public perception, inflation mismeasurement has balanced effects on the consumer price index.

The ECB launched its review of the monetary policy strategy after the meeting of the governing council in January. The monetary policy strategy was adopted in 1998 and clarified in 2003. The review is expected to conclude by end of this year and the ECB has stressed that all stakeholders will be engaged. The press release lists the following aspects to be reviewed:

• the quantitative formulation of price stability,
• the monetary policy toolkit,
• the effectiveness and potential side effects of the monetary policy (toolkit),
• the economic and monetary analysis,
• other goals such as financial stability, employment or environmental sustainability.

In this note, I review some aspects and recent arguments about changing the inflation target, evaluating the monetary policy toolkit and its unintended consequences and the mismeasurement of inflation.

The inflation target

The press release refers to the quantitative formulation of price stability. The primary objective of the ECB’s monetary policy is to maintain price stability and is established in the Treaty of the European Union. The ECB defines and implements the monetary policy of the Eurozone. The ECB aims at inflation rates of below, but close to, 2 % over the medium term. Inflation refers to a general increase in consumer prices and is measured by the harmonized index of consumer prices (HICP). To best serve its objective the ECB follows a two-pillar approach: economic and monetary analysis. The macroeconomic projections, which are published quarterly, form part of the economic analysis, monetary aggregates and credit development are part of the monetary analysis, which serves as a cross-check.

Compared to the single primary objective of price stability, for example, the U. S. Fed conducts its monetary policy to promote maximum employment, stable prices (‘dual mandate’) and moderate long-term interest rates in the U. S. economy. The Federal Open Market Committee sees stable prices at a rate of inflation of 2 % as being consistent with the dual mandate.

Given the long period of low inflation, there has been a lively debate about alternative inflation-targeting approaches. The low rate environment forces monetary policymakers to be more often constraint by the ‘zero lower bound’, when main policy interest rates reach zero. To overcome this problem, temporary price-level targeting has been proposed (Bernanke, 2019). The central bank would commit in advance to avoid raising interest rates at least until any shortfall of inflation from target had been fully offset so that average inflation over the period would equal the inflation target. This can be shown by comparing a standard Taylor rule to a price-level targeting rule (formula and graph see pdf-document).

The price-level targeting makes the inflation goal more symmetric as past shortfalls in inflation are compensating by subsequent periods of inflation overshooting above the target. The consequence for monetary policy is unambiguous: The path for the key interest diverges from the standard Taylor rule when actual inflation falls short of the target (around 2013) and indicates a level for the key interest which is ‘lower-for-longer’. Since it falls below zero, it implies a longer period of quantitative easing (large-scale asset purchases) by the ECB. Such policies lead to lower bond yields and higher expected inflation both reducing long-term real interest rates and higher expectations about future growth, which should encourage higher spending and economic activity in the first place. Any attempt for symmetry implies a commitment to keep interest rates low-for-longer.

The real natural rate of interest (also known as r*) has experienced a significant decline in advance economies. Forces at work are a lower trend productivity growth, demographic factors and an enhanced preference for safe assets. A lower r* leads to lower nominal interest rates and, hence, more frequent periods of interest rates hitting the ‘zero lower bound’ (i. e. reaching zero) hampering the ability of monetary policy to stabilize the economy and, hence, leading to a welfare loss.

There is a decreasing relationship between the real natural rate of interest and the optimal inflation target. A falling real natural rate of interest asks for a higher inflation target and the relationship can be as high as 1:1 (Andrade et al., 2019). While one can argue legitimately about the magnitude, it clearly indicates a higher inflation target for a low interest rate environment.

The monetary policy toolkit and its effectiveness

The effectiveness of monetary policy has been evaluated in several recent studies. Since the key interest rates reached zero, these studies look at the macroeconomic effects of unconventional monetary policy. Based on these macroeconomic studies, a consensus has built that unconventional monetary policy had beneficial effects on macroeconomic variables such as GDP and inflation. ECB staff estimates show a cumulative effect of 1.9 % for GDP (level) and an annual effect of about 0.5 %-age points on inflation for the 2016-19 period (Hartmann and Smets, 2018). Looking at various studies, the effect on output is positive but varies, while the effect on inflation is surprisingly consistent with an average effect of 0.6 %-age points (Table 1- see pdf).

It appears very unlikely that the ECBs strategic review would deviate from these findings. A part of these studies was conducted by staff members of the ECB and it is highly unlikely that new results would contradict the consensus that unconventional monetary policy was effective in raising output and inflation and, hence, supportive to reach the price stability goal of the ECB.

Unintended consequences of monetary policy

However, the review is also said to investigate unintended consequences of the long period of low or negative interest rates. Recently, a body of literature about negative side effects of monetary policy has emerged. Side effects include increasing difficulty of long-term private saving, the emergence of zombie firms and low productivity growth, distortions in financial intermediation and the rise of asset bubbles.

Zombie firms were initially found in Japan during the 1990s when misdirected bank lending prolonged economic stagnation. Banks financed weak, quasi-bankrupt companies. Competition with weak firms lowers healthy firms’ investment and profit, discourages market entries and decreases productivity (Caballero et al., 2008). The emergence of weak firms was also observed in Europe linked to malfunctioning insolvency regimes (Andrews and Petroulakis, 2019) and low interest rates (Banerjee and Hofmann, 2019). However, causal evidence for the relationship between low interest rates and rising shares of zombie firms remains weak and controversial (Bindseil and Schaaf, 2020).

Unintended effects of negative interest rates on banking systems were found for Switzerland and Eurozone. Negative interest rates led to balance sheet reduction, higher refinancing costs, higher duration mismatch, higher fees and risk-taking (Basten and Mariathasan, 2018). Retail banks reluctantly transfer negative interest rates to costumers causing higher risk-taking and lower lending (Heider et al., 2019).

Lower yields lead to a higher net present value of a future income in financial and real assets. Expectations about future prices increases give rise to speculative asset bubbles. “Lean-against-the-wind” monetary policy – detect and deflate asset bubbles by tightening monetary policy – is a subordinated monetary policy goal in the ECBs framework as financial stability is overseen by macroprudential policies conducted by national bodies. House prices have been rising in many (metropolitan) areas giving rise to concerns about new asset bubbles. For example, a recent study finds that QE (a balance sheet increase by 100 %) lead to a rise of real house prices by 17 % in Austria (De Luigi et al, 2019). However, a lower equilibrium interest rate (amid lower productivity growth and the demographic drag) is associated with higher price-to-rents ratios, i. e. rising house prices (Sommer et al., 2013). Against conventional wisdom, increases in interest rates in response to a growing bubble have been shown to enhance fluctuations in the bubble, hence, “lean-against-the-wind” monetary policy is ambiguous in the macroeconomic literature (Galí, 2014).

The (mis)measurement of inflation

The calculation of the harmonized consumer price index (HICP) by Eurostat has been subject to ongoing debate. It has been argued that actual inflation is higher than measured inflation. In fact, inflation underlies mismeasurement and most of the problems associated with the calculation of the consumer price index have been known for long but attract new attention amid its policy relevance. Usual biases involve recording of goods’ substitution, adjustments to quality improvement and the delayed inclusion of new goods. A regular adjustment of the consumer price baskets mitigates the substitution bias and the bias due to new products. Quality improvements can lead to inflation overestimation. The price of a good can remain unchanged, while the quality due to technological improvements gets better over time.

Online sales (for example, in Austria around 14 % of total sales) are not included in the index causing a too high measured inflation rate (due to online discounts), while missing owner-occupied housing in the index causes a too low HICP inflation. Critics argue that housing costs are not properly reflected in the HICP. However, a recent experimental study showed that the OOH inclusion (2011-15) would have had a minor effect of around 0.2 %-age points on the annual inflation rate (ECB, 2016). Recoding of new seasonal goods exaggerates negative price trends. Hence, mismeasurement leads to biases in both directions. Rumler (2019), who recently provided an overview, concluded that mismeasurement overall balances since it causes both over- and underestimation of inflation.

Summary

Those expecting the ECB’s strategic review to result in a lowering of the inflation target might get disappointed. Macroeconomic research recommends a higher inflation target to overcome the problem of near-zero nominal interest rates which are a consequence of the secular decline in equilibrium interest rates in advance economies. Furthermore, I believe that critics of ultra-loose monetary policy involving QE and negative interest rates might get disappointed. Macroeconomic research finds that QE works and is widely recognized as part of the toolkit of a central bank. However, given its prolonged periods, more attention must be drawn to the collateral damage from ultra-loose monetary policy. It is unclear how negative consequences resulting in a welfare loss for societies can be incorporated in the analysis framework of central banks. The discussion about inflation mismeasurement appears overdone. However, the inclusion of owner-occupied rents in the HICP, the policy relevant consumer price index, is subject to an ongoing debate. Recent research suggests that the effect on consumer price inflation is non-significant.


References: see pdf-document





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