What is left in the ECB toolbox?
In the Q&A session that followed yesterday's dovish monetary policy decision, the question of what remains in the ECB toolbox was raised a few times. To my understanding and my astonishment, Mario Draghi was neither clear nor convincing! In substance, he said that the ECB could do more of what it has done already…
Honestly, with a Negative Interest Rate Policy, a yield curve that looks like a flat line, a balance sheet in which about 25% of eligible bonds are stored and not much more than that can be bought according to constraints preventing outright monetary financing of government — the question is what else can the ECB do?
The way I see the situation is as follows. Central banks have reached a point where monetary policy is no longer able to reflate the economy, even though they are financially solid: they have money! Governments on the other hand are financially weak, they don't have money, but they can reflate the economy. Think of the Trump fiscal stimulus.
The "problem" is that central banks have gained independence from governments and cannot finance their debt. This time however, it could well be the case that governments have lost their independence and this is why their debt could be financed by central banks!
Imagine that there is a mild downturn at the corner and that inflation moderates further. Inflation targeting central banks in general, and the ECB in particular, are set to respond to this new situation according to their mandate. What if, in order to reach price stability, the ECB maintains — forever — the whole yield curve at ridiculously low levels so that governments can reflate their economies via massive debt-financed fiscal stimuli?
Isn't it a disturbing but elegant solution? By doing so, the central bank guarantees desperate investors they will have virtually no return on government debt holdings and no capital loss either, as the yield curve is controlled. To control the yield curve, central banks launched new types of QE, that we will call QI for quantitative inflation programme. Finally, governments get the needed fiscal room to reflate the economy under the control of a central bank that still acts according to its inflation targeting mandate. In other words, central banks and governments collaborate in this environment, but central bank independence remains as it adjusts the fiscal stimulus in terms of price stability.
This narrative sounds surreal, but it is not. By targeting the long-term rate at 0.1%, the BoJ allows government debt to skyrocket without anyone imagining a default at any time. In the United States, "monetary authorities were keen in fixing both the bill rate and the bond rate. This was particularly the case right after the Second World War, when government debts were enormous, as a result of the huge war effort that had produced large annual government deficits. It was then important for rates to be pegged at low rates, to avoid an excessive amount of debt servicing. Because investors knew that the long-term interest rate was pegged, it could be set at very low levels, because investors did not fear capital losses." (Wynne Godley and Marc Lavoie, Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, second edition, pp. 149-150.)
The way I present this "solution" sounds appealing, but it is clear that it raises many issues. A pegged yield curve does not contain any information as it does not react to changes in fundamentals, leading to misallocation of resources. In addition, to be effective, the yield curve has to be maintained at a level below where it should be. We don't need to use our imagination too much to recognize that there are parallels with currency pegs that from time to time are under pressure and de-peg eventually. This is not a panacea, but it could be used to smooth the next downturn.
Originally published on LinkedIn in January 2019 — an early formulation of ideas developed in Central Banks' Interest Rate Setting is Dead and Exchange Rate Policy.
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