STUDY Requested by the ECON committee Options for the ECB’s Monetary Policy Strategy Review Policy Department for Economic, Scientific and Quality of Life Policies Directorate-General for Internal Policies Authors: Yvan LENGWILER and Athanasios ORPHANIDES EN PE 652.753 - September 2020 Options for the ECB’s Monetary Policy Strategy Review Abstract The ECB is the most important institution for the success of the EMU. It started successfully but the crisis revealed weaknesses related to the incomplete nature of the EMU. The ECB was too timid in using its power, which deepened the euro crisis and led to divergences that threaten the viability of the EMU. With suitable modifications of its monetary policy strategy, and better use of the authority delegated to it, the ECB could greatly improve its success in fulfilling its mandate. This document was provided by Policy Department for Economic, Scientific and Quality of Life Policies at the request of the Committee on Economic and Monetary Affairs (ECON). This document was requested by the European Parliament's Committee on Economic and Monetary Affairs. AUTHORS Yvan LENGWILER, Faculty for Business and Economics, University of Basel Athanasios ORPHANIDES, Sloan School of Management, Massachusetts Institute of Technology ADMINISTRATOR RESPONSIBLE Drazen RAKIC EDITORIAL ASSISTANT Janetta CUJKOVA LINGUISTIC VERSIONS Original: EN ABOUT THE EDITOR Policy departments provide in-house and external expertise to support EP committees and other parliamentary bodies in shaping legislation and exercising democratic scrutiny over EU internal policies. To contact the Policy Department or to subscribe for email alert updates, please write to: Policy Department for Economic, Scientific and Quality of Life Policies European Parliament L-2929 - Luxembourg Email: [email protected] Manuscript completed: September 2020 Date of publication: September 2020 © European Union, 2020 This document is available on the internet at: http://www.europarl.europa.eu/supporting-analyses DISCLAIMER AND COPYRIGHT The opinions expressed in this document are the sole responsibility of the authors and do not necessarily represent the official position of the European Parliament. Reproduction and translation for non-commercial purposes are authorised, provided the source is acknowledged and the European Parliament is given prior notice and sent a copy. For citation purposes, the study should be referenced as: Lengwiler, Y. and Orphanides, A., Options for the ECB’s Monetary Policy Strategy Review, Study for the Committee on Economic and Monetary Affairs, Policy Department for Economic, Scientific and Quality of Life Policies, European Parliament, Luxembourg, 2020. © Cover image used under licence from Adobe Stock Options for the ECB’s Monetary Policy Strategy Review CONTENTS LIST OF ABBREVIATIONS 5 LIST OF BOXES 7 LIST OF FIGURES 7 LIST OF TABLES 7 EXECUTIVE SUMMARY 8 1. INTRODUCTION 12 2. THE INSTITUTIONAL FRAMEWORK 14 2.1. The EU, the EMU, and the objectives of the Union 14 2.2. Economic and monetary policy of the Union 15 2.3. The fiscal governance framework of the EMU 17 2.4. Prohibition of monetary financing and fiscal transfers 18 2.5. ECB discretionary authority 18 3. HISTORICAL OVERVIEW OF EURO AREA ECONOMY 20 3.1. Performance of the euro area economy in a global context 20 3.2. Monetary policy 23 3.3. Divergence of outcomes within euro area 26 3.4. The euro crisis 29 3.5. Impairment of the monetary policy transmission mechanism 31 4. THE ECB’S PRIMARY MANDATE OF PRICE STABILITY 36 4.1. The ECB’s original interpretation of its mandate 36 4.2. Evolution of ECB’s interpretation of its primary mandate 37 4.3. A comparison with other central banks: the 2% global benchmark 40 4.4. Assessing the ECB’s track record in achieving its primary mandate 41 4.5. Alternative approaches 45 5. THE BROADER MANDATE: SUPPORTING THE ECONOMIC POLICIES OF THE UNION 51 5.1. Comparison with other central banks 51 5.2. Potential conflicts associated with multiple objectives 52 5.3. Sustainable economic growth and full employment 52 5.4. Cohesion and solidarity among Member States 53 5.5. Environmental sustainability 54 5.6. Assessing the ECB’s track record in achieving its broader mandate 56 6. IMPLEMENTATION AND EFFECTIVENESS OF POLICY 57 3 PE 652.753 IPOL | Policy Department for Economic, Scientific and Quality of Life Policies 6.1. Original framework 57 6.2. The challenge of a low interest rate environment 60 6.3. Addressing the challenge 62 6.4. Systematic policy in a low interest rate environment 66 6.5. Assessing debt sustainability and sovereign credit risk 67 6.6. Collateral framework 71 7. THE RESPONSE TO THE PANDEMIC 76 7.1. The challenge 76 7.2. Three episodes in the ECB’s response 77 7.3. Issues well addressed … and a glaring shortcoming 79 8. RECOMMENDATIONS 81 9. CONCLUSION 84 REFERENCES 85 PE 652.753 4 Options for the ECB’s Monetary Policy Strategy Review LIST OF ABBREVIATIONS BIS Bank for International Settlements BOJ Bank of Japan CPI Consumer price index CRA Credit rating agency DSA Debt sustainability analysis ECB European Central Bank ELB Effective lower bound EMU Economic and Monetary Union ESCB European System of Central Banks ESG Environmental, social, and governance criteria Fed / FRB Federal Reserve Board FOMC Federal Open Market Committee FRED Federal Reserve Economic Data FSB Financial Stability Board GDP Gross Domestic Product GFC Global financial crisis HICP Harmonised index of consumer prices IMF International Monetary Fund LTRO Long term repo operations NCB National central bank NIRP Negative interest rate policy OIS Overnight indexed swap PCE Personal consumption expenditures price index 5 PE 652.753 IPOL | Policy Department for Economic, Scientific and Quality of Life Policies PEPP Pandemic emergency purchasing program PSI Private sector involvement PSPP Public sector purchase programme QE Quantitative easing SDW Statistical Data Warehouse SGP Stability and Growth Pact SNB Swiss National Bank SPF Survey of professional forecasters TEU Treaty on European Union TFEU Treaty on the Functioning of the European Union TLTRO Targeted longer-term refinancing operations US United States YCC Yield curve control ZLB Zero lower bound PE 652.753 6 Options for the ECB’s Monetary Policy Strategy Review LIST OF BOXES Box 1: Debt sustainability and multiple equilibria 33 Box 2: The interest rate assumption in DSA: Italy and Spain in summer 2012 69 Box 3: Compound interest and the sensitivity of DSA 70 Box 4: The cliff effect in Portugal 73 LIST OF FIGURES Figure 1: Headline and core inflation: Euro area and United States 21 Figure 2: Real GDP per capita and unemployment rate 22 Figure 3: Monetary policy: Euro Area and United States 24 Figure 4: Unemployment rate relative to pre-GFC average 27 Figure 5: Heterogeneity in core inflation 28 Figure 6: Monetary policy transmission at 2-year horizon 32 Figure 7: Primary balance and debt: Germany, Italy, Japan 34 Figure 8: Government bond yields, 2- and 10-year maturity: Germany, Italy, Japan 35 Figure 9: Evolution of long-term inflation expectations 38 Figure 10: Inflation swaps and HICP inflation 43 Figure 11: Communicating policy through inflation projections 47 Figure 12: Long-term surveys of inflation projections 48 Figure 13: Price level path targeting 50 Figure 14: Carbon footprint of EMU Member States 55 Figure 15: The ECB’s two-pillar strategy 58 Figure 16: Money and credit 59 Figure 17: Central bank balance sheets 64 Figure 18: Sovereign bond yields and OIS rates during pandemic 78 LIST OF TABLES Table 1: Inflation statistics, 1999 to 2019 44 Table 2: Recent inflation projections 76 7 PE 652.753 IPOL | Policy Department for Economic, Scientific and Quality of Life Policies EXECUTIVE SUMMARY Background The European Central Bank (ECB) is the most important institution for the success of the Economic and Monetary Union (EMU). It is more independent than its peer central banks of other advanced economies, and it has been entrusted with far broader discretionary authority to fulfil its mandate. However, its record has been uneven. Following a good start, that surpassed expectations, it was challenged during the global financial crisis (GFC) and the euro crisis that followed. Overall, the euro area performed worse than other advanced economies since the crisis. The ECB pursued a policy of lowflation that unnecessarily restricted growth and employment below what could be achieved without compromising price stability. In addition, ECB policies contributed to a sharp macroeconomic divergence within the EMU, a continuing source of fragility. A unique challenge for the ECB, relative to its peer central banks, is that it serves as the common central bank to multiple sovereign states that do not form a political union. In the absence of a common government and common fiscal policy, the ECB is confronted with political pressure and legal challenges that reflect conflicting national interests. The prohibition of monetary financing and fiscal transfers, in particular, has been invoked to challenge ECB policy. We find that the ECB has the independence and authority to fulfil its mandate better, but has been too timid to use its power, owing to an overcautious interpretation of these prohibitions. The ongoing review of the ECB’s monetary policy strategy can examine improvements on several dimensions. Two weaknesses stand out and demand urgent attention. First is the lack of a precise definition of the ECB’s interpretation of its primary mandate of price stability. Unlike all other major advanced economy central banks that have adopted a clear 2% inflation goal as their definition of price stability, the ECB’s interpretation remains vague. This makes monetary policy less effective in general, but especially so in the face of adverse developments such as the ongoing pandemic. Adopting a 2% inflation goal the soonest would re-anchor inflation expectations and improve the ECB’s ability to promote growth and employment without prejudice to price stability, in accordance to its mandate.