19th Mar 2018


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.

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Yet due to the crisis this distinction between conventional and unconventional policy is seriously out of date.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


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