Can the ECB insure against financial instability ad vitam eternam?

The ECB between redemption and reinvestment

It took until October 2017 for the ECB to announce that it would reduce the pace of its bond purchases. From January 2018 onwards, monthly ECB asset purchases will decline from €60bn to €30bn. But forward guidance remains untouched: policy rates will only start to rise “well past” the end of asset purchases. Moreover, the ECB will reinvest (emphasis not added) the proceeds from maturing bonds so that the total size of its QE programme will continue to increase. That unambiguously sets the tone: to avoid a “taper tantrum”, just don’t taper altogether! And to buy insurance against financial instability, one moto: be prudent and buy time. This is an expression of what economists know well as “Brainard uncertainty”, which brings an argument in favour of caution for central banks. When you do not know how the economy is going to react to your policy actions, do less rather than more.

Admittedly, the ECB could even decide to fine tune this new balance sheet trajectory for a few months if new risk factors were to emerge. Yet, other factors would suggest that the time has come to at least stabilise the size of the ECB’s balance sheet. The Brainard argument notwithstanding, the case to wait is, to say the least, mitigated.

Views are more contrasted when it comes to interest rate decisions. Many observers do not foresee interest rate increases before the very end of 2019 - in more than two years! However, the macroeconomic and financial environment of the euro area is gradually becoming compatible with an earlier neutralisation of the policy stance. In that spirit, even though President Draghi confirmed that rate hikes could only restart once QE stabilises, there is nothing to prevent the central bank from preparing the markets for a rise in interest rates much earlier than that. This is the old-time inconsistency over again: ex post, the ECB will have incentives to start signalling interest rate normalisation earlier than it said it would.

Transmission through non-banks, another reason for caution?

Looking through such conjunctural factors, fundamental questions about the transmission of monetary policy - i.e. the ways through which the central bank affects inflation and economic growth - arise.

The transmission of monetary policy is likely to change fundamentally in the future because the financial structure of the euro area is itself mutating. The ECB itself notes in its freshly published report on the euro area financial structures that the universe of non-banks has grown substantially onver the past decade and sometimes performs bank-like functions. This calls for a more holistic approach to the transmission of its monetary policy for sure. The relative and absolute size of the non-bank financial sector - insurance companies, pension funds, asset managers and other financial intermediaries - increased significantly between 2008 and 2015, as a share of GDP. This deep structural change will be critical to understand when and how fast the ECB will have (be able?) to raise its rates.

Even if the growth of the non-bank financial sector also knows its ups and downs - especially because of valuation effects - this silent revolution in the population of financial intermediaries that allocate savings in the economy is only starting. Does it add, or substract, to the “Brainard uncertainty” mentioned above? One could hope that this diversification of the financial ecosystem should be a factor of resilience...were it not for the common vulnerability of all players to the possibly massive valuation effects that any interest rate increase will entail, and the contagious network effects that may amplify in unknown ways outside of the banking sector. Yet another reason for the ECB to be cautious...despite the asset price bubbles surrounding us.

Views expressed in this blog are the author’s own. They reflect statements made at the Annual FMA Aufsichtskonferenz 2017 held in Vienna on 4 October 2017 and at the European Long-Term Investment Conference held in Brussels on 26 October 2017.

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