Nout Wellink: Monetary Policy in Europe--Exit Problems

2017-12-03 IMI

Nout Wellink, Member of IMI International Advisory Board, Former President of the Dutch Central Bank. In 2007/2008 central banks came to the rescue of the system. Initially they used their traditional instruments, but step by step they also introduced so-called unconvential policies: forward guidance and quantitative easing. Starting such a policy is relatively easy, ending is more complex. A balanced, well-communicated, flexible enough exit from the present, ultra loose monetary policy by the ECB is key to a smooth functioning of financial markets. In the following I want to focus on the present, to my mind problematic exit-strategy of the ECB. A dovish meeting The ECB was remarkably dovish at its last (25/26 October) meeting. Although it halved its monthly bond buying program for the first 9 months of 2018 from 60 to 30 bln., Mario Draghi stressed several times during the press conference that the decision was for an open-ended programme, adding to it :“certainly it’s not going to stop suddenly. It’s open-ended and the large majority expressed its preference for keeping it open-ended”. So, Draghi clearly announced some further extension of the programme after September 2018. It might be an extension for small amounts and/or a very short period, three months for example, but an extension he promised. This announcement was done during the press conference and not in the press communique. Therefore it remains to be seen whether other governors feel committed. However, if Draghi does not deliver his credibility is at stake. He indirectly paved the road for a further extension by going out of his way in the press conference to stress the flexibility of the programme. He also made it clear that he does not agree with those who fear a scarcity of available assets or an overrun of the self-imposed issuer/issuance limits. The importance of open-endedness Why is it so important that the programme is still open-ended? First and foremost, because it keeps all options open for the period after september 2018. That is self-evident. Secondly, Draghi’s remark that “certainly it is not going to stop suddenly” delays the moment that key policy rates will go up. Why? For several years in a row the ECB-mantra is that it continues to expect the key ECB interest rates “ to remain at their present levels for an extended period of time, and well past the horizon of our net asset purchases”. Draghi sees the phrase “well past” as crucial, as “very, very important in anchoring rate expectations” (12 October, Washington). So, if you move the horizon of ending the net purchases backwards, you also move backwards the moment that policy rates will go up. Not only a future increase in key ECB rates is linked to the termination of net purchases but also the reinvestments from maturing securities are: “The ECB also decided to reinvest the principal payments from maturing securities purchased under the APP for an extended period of time after the end of its net asset purchases, and in any case as long as necessary”. So, there is a clear commitment that it will take an extended period after the horizon of net asset purchases before the ECB will start shrinking its balance sheet and tightening via this channel its policy. Mind you, these two pledges - repeated by Draghi in a Committee meeting of the European Parliament on 20 November - are regardless the fact that the European economy is already growing for more than four years in a row and at present on a 2.5% growth path, with unemployment at its lowest level since January 2009). Why this ultra loose monetary policy Why is Mr Draghi so adamant to continue the ECB’s ultra-loose monetary policy, supported by a clear Governing Council majority. Some time ago Draghi introduced the three p’s: patience, prudence and persistence. Sticking to the three p’s is in his view necessary to realize “a sustained adjustment in the path of inflation consistent with the ECB’s inflation aim of close to but below 2%”. A few years ago he called the latter “a moral and legal obligation”. The ECB says it needs to be sufficiently convinced that inflation is on a sustainable path to (close to) 2% before ending net asset purchases. If that moment, the moment of the ending of the net asset purchases, would arrive, the ECB runs to my mind, potentially at least, into serious communication and credibility problems. It has committed and is still committing itself, as of today, in clear, unconditional terms that the next policy steps ( the shrinking of its balance sheet and the increase in key policy rates) will only take place after an extended period/ well past the horizon of the ending of net asset purchases. So, the officially communicated exit-policy at this very moment is to only tighten monetary policy well past the moment that inflation is at a sustainable path close to 2%. It makes no sense that, regardless the economic situation (knowing that we are now already on a 2.5% growth path) the ECB is still sticking, almost blindfold, to its earlier promises. By this approach the ECB is painting itself into a corner and threatens to become the prisoner of its own wordings. I can only understand the present approach if the Governing Council is prepared to take the risk of a higher inflation than 2%, after so many years of falling short of the target. But then they should be transparant about this policy. The inflation mystery Let’s now reflect on what would happen if inflation in the coming period does not go, in a sustainable way, fast enough into the direction of (close to) 2%. Also in that case there is a growing communication/exit problem. Inflation in the major economic blocs remains surprisingly soft. Central bankers best guess is that consumer prices will soon accelerate, but they don’t have a good explanation for the time and again disappointing inflation figures. In the absence of a good explanation for the low inflation rate, while running the risk of a continuation of the present low inflation environment, it is dangerous to have a “Whatever it takes” attitude to realize the (close to)2% goal. Such an approach might result in a completely unbalanced monetary policy. Eventually a central bank is capable of generating nearly any amount of inflation, but after a certain moment finetuning is not possible anymore and serious negative side-effects set in. To my mind the already long period of low inflation is due to globalisation, technological developments, including the use of the internet, and demographic developments. That is not to say that inflation will not pick up at a certain moment, but it implies that central banks should be less obsessed by a very precise inflation target. Otherwise they run the risk of pursuing too loose a monetary policy for too long a period. A looming danger Everything looks fine and dandy in the world economy at the moment.For the time being the assumption is that this will remain so for at least the next few years. But what if, within the “monetary policy normalization period”, verbally so much extended by the ECB, the world is hit by a slowdown in growth? If the ECB has not started in time with reducing its balance sheet and increasing its policy rates, a very unpleasant picture emerges. Insufficient normalization means that when the next crisis will hit us, for whatever reasons, the monetary toolbox of the ECB is almost empty. In conclusion The ECB should adjustits self-imposed, irrational exit strategy, caused by sticking too long to certain exit phrases. There seems, from a broader risk management point of view, no alternative to changing its policy and communication strategy. That will not be easy, taking into account the strong views which, until very recently have been taken by the majority of the Governing Concil. At the end of the day, and regardless what has been said in the past, the reality is that in a booming economy central banks have to tighten their policies, even if inflation is not at the targeted value and/or even if they have promised to wait with further tightening for an extended period of time after ending net asset purchases. And if - for whatever reasons -the economy does not remain on track, too delayed a start of the tightening cycle will leave the ECB with an empty monetary toolbox.

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Nout Wellink: Monetary Policy in Europe--Exit Problems

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