The 2017 edition of the CFS - ECB Watchers Conference in Frankfurt gave the ECB the opportunity to signal it would remain prudent towards geopolitical risks and the dangers of bank and sovereign legacy assets in the euro area. The current monetary policy stance is very loose, but for the ECB, financial and political risks dominate the macroeconomic logics. But policy normalisation will be challenging. Meanwhile, domestic and international stabilisation tools can be used more effectively. Arguments are summarised below in the form of Q&A.
Q1: How can the current stance of monetary policy in the euro area be judged?
A: (Too) loose, but the ECB has little leeway.
Relative to previous years, headline inflation is normalizing and the growth environment has become more benign. A literal interpretation of the mandate of the ECB would call for a gradual adjustment of monetary policy from its currently loose stance. This being said, tail risks, both of political nature and related to the financial stability implications related to the necessary treatment of legacy assets in specific pouches of the banking system, still prevail. They might explain why the ECB doesn't seem to be in a hurry to neutralise its monetary policy stance.
Q2: What are the challenges of an – eventually inevitable - monetary policy normalization in the euro area?
A: Balance sheet adjustment and fical dominance.
The biggest challenge ahead in the "normalisation debate" will be for the ECB to decide whether it intends to return its balance sheet to its pre-2008 size and drive the banking system back into a structural liquidity shortage to implement monetary policy - the alternative being to retain a balance sheet size that is very large relative to GDP. Both options have pros and cons, but the euro area faces a situation that is historically specific: pervasive legacy assets in the banking system and contingent liabilities in the public sector. Whichever option is chosen for the "new normal", these assets and liabilities will impose challenges on the central bank. As both the guardian of financial stability and holder of massive sovereign debt portfolios, it might prove difficult for monetary authorities to implement their desired stance without taking into account the possible boomerang effects of its actions on itself. These constraints could indeed resemble the symptoms of fiscal dominance - but would it be for the better or for the worst, if it is the price to pay to save the euro?
Q3: How can the current macroeconomic policy framework in the European Monetary Union become appropriate to deal with asymmetric economic shocks?
A: Use existing tools more proactively!
The macroeconomic policy framework of EMU is still far from complete. But we should not underestimate the power of the institutions and tools that already exist. For instance, a number of proposals being made to establish a fiscal capacity for the euro area are viewed as unrealistic at the current juncture: but do we really need to establish new joint functions (such as a common unemployment scheme for instance), new fiscal resources, or new joint debt instruments for the single currency to be viable? It is not clear. Institutions such as the European Stability Mechanism or the European Investment Bank are there, already up and running. Letting them play their role fully would go a long way to develop cross border financial linkages and act as macroeconomic stabilisation tools while reducing financial stability risks associated with macroeconomic imbalances.
Q4: How desirable and feasible is a stronger international coordination of monetary policies?
A: Very desirable, also feasible with central bank currency swaps.
The international monetary system is undergoing a profound shift. From a longer term perspective - ie, looking through the sudden stop that occurred with the 2008 financial crisis - the explosion is size of gross international investment positions means that volatility regimes, exchange rate movements and relative monetary policy developments across dominant currencies are more likely than in the past to have an impact of the prosperity and wealth of nations. In such an environment, stronger international policy cooperation is of the essence, also - to the extent possible - for monetary policy. The generalisation of swap agreements across major central banks is, to my view, a game changer to that respect. Combined with macro-prudential measures devoted to the management of cross border capital flows, swaps should insure the world against "extreme events" such as currency collapses. They should be generalized.
Q5: What is the biggest risk to the euro area economy in the near future?
A: Lex monetae!
Risks to economic developments in the single currency area go beyond the borders of economics and entail a mix of political and social factors. In the very short term, one cannot ignore the fact that terms such as "lex monetae" or "Article 50" have found their way to the broad public debate, fostered by political agendas hostile to Europe. There, the survival of the euro is at stake. But beyond electoral outcomes in 2017, a well identified tryptic needs to be monitored. The implementation of structural reforms in some countries of the "old core" or Europe is one key element. The use of fiscal space in countries that can afford it to make up for investment gaps that have built over years, in particular in the public sphere, is another. Last, mutual trust should be preserved or reestablished whenever endangered, because without it, the best institutions and governance in the world would fail to build a joint future.
A shorter version of this blog has been published in the booklet produced for the 2017 ECB Watchers Conference held in April 2017 in Frankfurt. Views expressed in this blog are the author’s own.