The writer, a former head of the IMF’s European department, is chief economic adviser at Morgan Stanley
The European Central Bank ended 2020 with a flourish, following up the successful stabilisation of markets with fresh measures to ensure easy financing conditions in the coming year. So is that the end of the line for monetary stimulus? What should we expect in 2021?
Three challenges will loom large at the ECB as the continent transitions to a post-vaccine, post-pandemic world: the problem of chronically low inflation; the tools to tackle it; and the link to climate policy. These may seem like long-term issues but are of acute interest to forward-looking financial markets as they bear on how long easy financial conditions might persist.
All three issues are to be taken up in a forthcoming strategy review, which is likely to be the ECB’s most consequential policy pronouncement in 2021.
First, the inflation challenge. Considering the ECB’s success in stabilising markets and holding the eurozone together, its failure to deliver on its core mandate — inflation “close to but under 2 per cent” — is remarkable. Inflation has been closer to 1 than to 2 per cent for seven of the past eight years, and markets expect that will be the case for the next decade.
The shortfall is not just a problem for debtors, who end up paying more in real terms than they bargained for. It is also a problem for a central bank effectiveness once expectations, in the face of systematic error in one direction, start to adjust.
Thus, the ECB may have succeeded in pushing down nominal interest rates, but since inflation expectations have also fallen, the decline in expected real rates — the key variable for savers and investors — has been more modest. Keep this up and a central bank loses all traction. Some commentators already bracket the ECB with the Bank of Japan, which lost control of its inflation anchor to become an institution perpetually at war with deflation.
Avoiding such a fate requires removing the ambiguity and ambivalence surrounding the ECB’s “close to but under 2 per cent” target. This has become a bigger issue since an influential minority in the ECB’s governing council has made clear it sees no problem in low inflation. The hawks favour a lower target range that would allow the ECB to declare victory and end monetary easing sooner. But lower inflation is the last thing a currency zone ridden with debt, wage rigidities and differing vulnerabilities needs.
Rather, the ECB should look to eliminate the “close to but under” clause attached to its current target. Alternatively, it could follow the US Federal Reserve’s lead in adopting an average inflation target, which, by encouraging expectations of above 2 per cent inflation in coming years, could counter the inflation pessimism that pervades Europe.
Second, the toolset. It is unclear if the strategy review will produce more than tweaks to the ECB’s asset purchase and credit subsidy programmes. A bolder move would be to expand into private asset purchases and revive short-term interest rates as an active policy tool. The latter was set aside in the belief that rates cannot be taken much below zero without harming banks.
But there are ways around the problem, and the prospect of a digital euro issued by the ECB, on which a small fee can be imposed, opens the door to more negative interest rates without undermining banks.
A more potent tool to raise inflation expectations involves breaking a taboo: co-ordination with fiscal policy. The proscription made sense in a world of robust growth, where any hint of collusion with fiscal authorities risked igniting inflation. But that world is long gone.
In the new secularly stagnating one, sustained public investment will be key to lifting demand, growth and inflation. The ECB has been supportive of fiscal expansion during the pandemic, but whether this stance will continue is unclear, placing question marks over inflation prospects. A more overt co-ordination with fiscal authorities, without underwriting profligacy or violating monetary financing of deficit rules, is well within the ken of the ECB.
Third, climate change. This is not an issue usually associated with central banking. But it has become relevant as green spending is a focus of the EU’s recovery fund.
Moreover, recognition of the financial risks stemming from climate change is growing. The ECB will need to go beyond insisting on transparency about climate risks in bank portfolios to actually incorporating these risks in its operations — be that in stress tests, capital requirements or eligibility for ECB asset purchases and collateral.
It is a well-worn trope in European policy circles that nothing changes outside of a crisis. If the ECB is to succeed in the coming decade, not just in 2021, it will need to prove itself the exception to that rule.