Monday

18th Dec 2017

Opinion

The ECB and low inflation: no such thing as conventional policy

The eurozone has been suffering from record low inflation for several months now. Last October the inflation rate dropped below 1 percent and has remained there ever since.

This low pace of price increases is dangerous because it undermines growth and makes our debt piles even more difficult to handle. The situation is beginning to resemble the ‘lost decade’ that Japan endured in the 1990s.

Thank you for reading EUobserver!

Subscribe now for a 30 day free trial.

  1. €150 per year
  2. or €15 per month
  3. Cancel anytime

EUobserver is an independent, not-for-profit news organization that publishes daily news reports, analysis, and investigations from Brussels and the EU member states. We are an indispensable news source for anyone who wants to know what is going on in the EU.

We are mainly funded by advertising and subscription revenues. As advertising revenues are falling fast, we depend on subscription revenues to support our journalism.

For group, corporate or student subscriptions, please contact us. See also our full Terms of Use.

If you already have an account click here to login.

After a long period of hesitation, the European Central Bank (ECB) finally seems ready to counter low inflation. The ECB appears to have set out an order of play in which it first exhausts ‘conventional’ monetary policy, before considering ‘unconventional’ policy.

Yet due to the crisis this distinction between conventional and unconventional policy is seriously out of date.

Unusual ‘conventional’ policy

’Conventional’ monetary policy refers to a modification of the ECB’s interest rates, which was indeed the usual policy instrument before the crisis. These interest rates are now at an all-time low.

The rate at which banks can borrow from the ECB stands at only 0.25 percent. The rate on the ECB’s deposit facility – the remuneration that banks receive for placing their money in the ECB – is as low as 0 percent.

The latter means that banks no longer get compensation for the money they put into the ECB.

However, it is arbitrary to define a further cut in the ECB’s interest rates as conventional policy. This holds particularly true for the interest rate on the deposit facility, as this rate would turn negative. As a result, banks would actually have to pay to place money in the ECB.

In terms of monetary policy, such a negative deposit rate would be highly unusual.

Only a couple of smaller central banks, like those of Denmark and Sweden, have ventured into this territory.

If the ECB were to become the first major central bank to push its deposit facility into negative territory, this would be a historical decision with uncertain consequences. It would, in any case, not be conventional.

Quantitative easing

So what exactly is ‘unconventional’ policy, if it is defined in opposition to ‘conventional’ policy?

The concept refers to instruments that are not part of the regular toolbox of central banks. The best known type of such unconventional policy is ‘quantitative easing’, through which a central bank buys bonds or other securities in the financial market.

The result is an expansion of the money supply, which can lead to economic growth and/or higher inflation.

While quantitative easing was unconventional before the crisis, this is in fact no longer the case. The Fed, the Bank of England and the Bank of Japan – all the major central banks in industrialised economies – have embraced quantitative easing during the crisis.

That is, all but the ECB which has been most cautious with regard to unconventional monetary policy.

Nonetheless, at high points of the crisis, it did undertake such policies. The Outright Monetary Transactions (OMT) programme for indebted eurozone countries and the long-term loans to the financial sector are the clearest examples.

Hence ‘unconventional’ by no means equals ‘unknown’.

New monetary policy territory

Despite the theoretical distinction between conventional and unconventional monetary policy, the reality is that we have been deep in new monetary policy territory for some time now.

Due to the once-in-a-lifetime economic and financial crisis, all monetary policy has actually become highly unconventional.

To depict lowering the interest rate of the ECB’s deposit facility as a conventional and therefore the safe choice is incorrect.

In many ways, quantitative easing is actually the prudent tactic. In terms of monetary policy therefore, the division between conventional and unconventional policy is a myth.

If the ECB decided on a negative interest rate for its deposit facility without quantitative easing, this should not be viewed as the exhaustion of its conventional policy.

The decision might be the right one to make, but the ECB should provide a thorough explanation of exactly why it is the right choice.

Reliance on the myth of conventional monetary policy should not be a part of that explanation.

The writer is Senior Research Fellow at EGMONT Royal Institute for International Relations, an independent think-tank based in Brussels

Analysis

Deflation in Europe: curse, ogre or benign?

The eurozone economy has never experienced a protracted period of deflation. That is what is facing it now. The question is whether it matters.

Iceland: further from EU membership than ever

With fewer pro-EU MPs in the Iceland parliament than ever before, any plans to resume 'candidate' membership of the bloc are likely to remain on ice, as the country prioritises national sovereignty and a more left-wing path.

Stakeholders' Highlights

  1. Dialogue PlatformThe Gülen Community: Who to Believe - Politicians or Actions?" by Thomas Michel
  2. Plastics Recyclers Europe65% plastics recycling rate attainable by 2025 new study shows
  3. European Heart NetworkCommissioner Andriukaitis' Address to EHN on the Occasion of Its 25th Anniversary
  4. ACCACFOs Risk Losing Relevance If They Do Not Embrace Technology
  5. UNICEFMake the Digital World Safer for Children & Increase Access for the Most Disadvantaged
  6. European Jewish CongressWelcomes Recognition of Jerusalem as the Capital of Israel and Calls on EU States to Follow Suit
  7. Mission of China to the EUChina and EU Boost Innovation Cooperation Under Horizon 2020
  8. European Gaming & Betting AssociationJuncker’s "Political" Commission Leaves Gambling Reforms to the Court
  9. AJC Transatlantic InstituteAJC Applauds U.S. Recognition of Jerusalem as Israel’s Capital City
  10. EU2017EEEU Telecom Ministers Reached an Agreement on the 5G Roadmap
  11. European Friends of ArmeniaEU-Armenia Relations in the CEPA Era: What's Next?
  12. Mission of China to the EU16+1 Cooperation Injects New Vigour Into China-EU Ties

Latest News

  1. Far-right enters government in Austria
  2. UK should work more closely with MEPs on Brexit
  3. EU set to probe Ikea tax affairs
  4. Estonia's last chance to land green energy results
  5. Catalonia, Brexit, and Uber on EU agenda This WEEK
  6. Macron and Merkel take tough line on Poland
  7. Eurozone future needs structural reforms, EU leaders told
  8. Showdown EU vote on asylum looking likely for next June

Stakeholders' Highlights

  1. EPSUEU Blacklist of Tax Havens Is a Sham
  2. EU2017EERole of Culture in Building Cohesive Societies in Europe
  3. ILGA EuropeCongratulations to Austria - Court Overturns Barriers to Equal Marriage
  4. Centre Maurits CoppietersCelebrating Diversity, Citizenship and the European Project With Fundació Josep Irla
  5. European Healthy Lifestyle AllianceUnderstanding the Social Consequences of Obesity
  6. Union for the MediterraneanMediterranean Countries Commit to Strengthening Women's Role in Region
  7. Bio-Based IndustriesRegistration for BBI JU Stakeholder Forum about to close. Last chance to register!
  8. European Heart NetworkThe Time Is Ripe for Simplified Front-Of-Pack Nutrition Labelling
  9. Counter BalanceNew EU External Investment Plan Risks Sidelining Development Objectives
  10. EU2017EEEAS Calls for Eastern Partnership Countries to Enter EU Market Through Estonia
  11. Dialogue PlatformThe Turkey I No Longer Know
  12. World Vision7 Million Children at Risk in the DRC: Donor Meeting to Focus on Saving More Lives