25 September 2019

Bruegel: Challenges ahead for the European Central Bank: Navigating in the dark?

The ECB will face major challenges in this potentially difficult period: its main tools are nearly exhausted, the monetary union in which it operates is still incomplete, and it lacks the understanding of what the ‘new normal’ looks like. The authors, therefore, urge the ECB to review its strategy and framework to be able to face these challenges.

The European Central Bank (ECB) has faced major challenges in the last decade: the global financial crisis, the Great Recession and the euro crisis, resulting in the worst economic situation since the Great Depression. These events made it difficult for the ECB to fulfil its price stability mandate as deflation risks mounted (especially after the double-dip recession) and transmission channels were broken because of the banking crisis and the sovereign debt crisis in some euro-area countries.

The ECB responded to the events of the last ten years by expanding its toolbox significantly with the introduction of negative rates, generous long-term refinancing operations for banks, forward guidance, massive asset purchases, and tools to restore the transmission channel in all countries (Securities Markets Programme and Outright Monetary Transactions).

As a result, the situation has improved in the euro area: deflation risks have abated, the economic recovery that started in mid-2013 has accelerated, investment has picked up, and unemployment has fallen considerably in the euro area as a whole.

However, since the second half of 2018, signs of a slowdown have been piling up, as the euro area – which has become very vulnerable to external shocks because of its reliance on exports in recent years – has been heavily affected by global trade tensions. Major euro-area countries including Germany and Italy might already be in a recession. After peaking at around 2 percent at the end of 2018, headline inflation has decelerated again in recent months, market expectations have decreased to near their lowest historical levels, and core inflation is still stuck at around 1 percent.

The ECB enters this potentially difficult period with limited space to cut rates and a large balance sheet, making it more difficult to use its current conventional and unconventional tools. In addition, the marginal return on these tools might be diminishing. This represents a major challenge for the ECB which will have to review its strategy and toolbox, and innovate further in the next few years to be able to fulfil its mandate.

Another major challenge for the ECB is the peculiar, incomplete nature of monetary union, in which coordination between monetary and fiscal policy is flawed. There is no fiscal tool at the euro-area level, and national fiscal policies are under greater market scrutiny than in other jurisdiction because of the prohibition of monetary financing, which can result in self-fulfilling liquidity crises, especially in countries with more fragile debt situations. This gives the ECB a crucial role to play in the euro-area architecture.

A third challenge is the lack of understanding of what the ‘new normal’ looks like. Neutral rates, which are an important guide for policy rates, have probably declined, but the estimates are poor and it is difficult to know if the current historically low level of rates are a short-term phenomenon or a secular one. More generally, this shows that the central banks’ underlying models – their interpretation of how the economy works – are also poor.

To be able to face these challenges, authors urge the ECB to review its strategy and framework, including the way its target is precisely defined.

They also urge the ECB to be ready to apply all the tools at its disposal if the economic situation deteriorates (quantitative easing, generous refinancing operations, forward guidance, etc) and to start thinking about other potential tools if the current ones are insufficient (e.g. helicopter money, etc). But the ECB must also be ready to use Outright Monetary Transactions (OMT) in case sovereign debt markets face new liquidity crises.

Finally, despite the primacy of its price stability mandate, the ECB will have to play an important role in promoting financial stability. Low rates for a long period, which are necessary to bring inflation back to 2 percent and support growth, could nevertheless have some financial stability implications, meaning the ECB could face some dilemmas in the future. This means that macro-prudential measures will have to be the first line of defence against financial imbalances. The current institutional setup in the euro area might not be capable of doing that. Therefore, the ECB should contribute to stronger analytical foundations for these policies, make proposals to improve the European framework and monitor carefully the financial stability risk to alert the institutions responsible for implementing these policies.

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