Pandemic Monetary Policy - Key Policy Lessons from European Central Bank

The objective of this article is to highlight the monetary policy decision of the European Central Bank yesterday (9 September 2021) and its important aspects as the learning outcome.

What is the European Central Bank (ECB)?

The ECB is the only central bank that does not belong to any one country or government. It was established in 2009 as the central bank for the European Union (EU) except for the UK. Accordingly, the monetary policy of the EU with a new currency “Euro” for the objective of price stability was handed over to the ECB whereas country central banks discontinued their domestic currencies and monetary policies and continued banking operations in Euro currency with the banks and government and bank supervision functions. The ECB also makes policy decisions on financial sector supervision and stability in addition to the monetary policy.

The Euro was first introduced to financial markets on 1 January 1999 as an accounting currency, replacing the ECU (European Currency Unit). The Euro coins and notes (currency) were put into circulation in member countries on 1 January 2002. By March 2002, the Euro replaced all local currencies of members and became the legal tender in EU countries.

At present, the Euro is a global reserve currency with the second-highest share (nearly 21.2%) in global official foreign reserves (highest is the US$ with 60%). However, the Euro is a widely used currency used freely for global trade and investments. The exchange rates of the Euro are determined in currency markets as the ECB does not intervene or target any exchange rates.

ECB's Present Monetary Policy Instruments

At present, the EU has 19 country members. The channels of the inflow of Euro or money printing to EU member countries include four instruments.

• Long-term refinancing to Euro area banks for on-lending to the private and public sectors

• Purchase of member country government securities (lending to EU governments) and corporate securities (lending to private sector) from the market

• Overnight money market operations (overnight lending and deposits) with banks

• Key policy interest rates - main refinancing operations rate, marginal lending facility rate (overnight) and deposits facility rate (overnight)

Accordingly, monetary conditions (interest rates, credit and money circulation/supply) in the EU are largely determined by the ECB’s monetary policy decisions taken based on the targets for the price stability or inflation in the EU area.

ECB's Present Monetary Policy Background

Similar to historic monetary policy relaxations adopted by central banks in developed countries in response to the onset of the global Corona pandemic in early 2020, the ECB further relaxed its monetary policy from already relaxed level that had prevailed since early 2008 consequent to global financial crisis 2007/09.

Followings are the highlights of relaxations that were intended to ease financing conditions to avert possible occurrence of any liquidity crunch in the EU due to pandemic-related uncertainties and to keep financial markets active and stable.

• 2 March 2020 – ECB President’s statement to take appropriate and targeted measures, as necessary and commensurate with the underlying risks.

• 12 March 2020
• Three policy interest rates unchanged, main refinancing operations at 0.25%, marginal lending facility at 0% and the deposit facility at -0.50%. This level was there for the past decade.

• Additional longer-term refinancing operations (LTRO) to be conducted, temporarily, to provide immediate liquidity support to the euro area financial system.

• Considerably more favourable terms to be applied during the period from June 2020 to June 2021 to all targeted LTRO III (TLTRO) operations outstanding during that same time.

• A temporary envelope of additional net asset purchases of €120 billion under the prevailing asset purchase programme (APP) until the end of the year.

• Reinvestments of the principal payments from maturing securities purchased under the APP to continue, in full.

• 10 April 2020 - New series of seven additional longer-term refinancing operations, called pandemic emergency longer-term refinancing operations (PELTROs) with the interest rate of 25 basis points below the average rate applied for main refinancing operations (currently 0%) over the life of the respective PELTRO.

• 4 June 2020
•  Extra € 600 bn to PEPP increasing it to € 1,350 bn and extend the time horizon of the PEPP to at least the end of June 2021.

• Reinvest the maturing principal payments from securities purchased under the PEPP until at least the end of 2022.

• Net purchases under APP to continue at a monthly pace of €20 billion, together with the purchases under the additional €120 billion temporary envelope until the end of the year.

• Continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when the ECB starts raising the key policy interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

• 10 December 2020 - Increase the envelope of PEPP by €500 billion to a total of €1,850 billion.

• Inflation (consumer) target 2% symmetric basis over the medium term (up to July 2021, the inflation target was “close to but below 2%”).

ECB’s Monetary Policy Decision - 9 September 2021

• To keep its present monetary policy stance largely unchanged.

• To conduct net asset purchases under the PEPP with a total envelope of €1,850 billion until at least the end of March 2022 and, in any case, until ECB judges that the coronavirus crisis phase is over.

• To maintain net asset purchases under PEPP at a moderately lower phase than in the previous two quarters.

• Net purchases under the APP to continue at a monthly pace of €20 billion and to run it for as long as necessary until shortly before ECB starts raising key policy interest rates.

Background of ECB's Policy Decision 

• The recovery continues to depend on the course of the pandemic and progress with vaccinations.

• With European adults more than 70% fully vaccinated, the economy has largely reopened, allowing consumers to spend more and companies to increase production.

• However, risks to the economic outlook are broadly balanced at present.

• Financing conditions for all sectors have remained favourable. Favourable financing conditions are essential for the economy to continue its recovery and to offset the negative impact of the pandemic on inflation.

• Economic activity could outperform expectations if consumers become more confident and save less than currently expected.

• Real GDP growth in 2^nd Quarter – 2.2% (Project annual real GDP growth at 5.0 %in 2021, 4.6% in 2022 and 2.1% in 2023).

• Inflation in August – 3.0% (as against the inflation target of 2% symmetric over medium term), a steady gradual increase from negative 0.4% in December 2020 (Project annual inflation at 2.2% in 2021, 1.7% in 2022 and 1.5% in 2023). The current rise in inflation is expected to be largely temporary whereas underlying price pressures are building up only slowly.

• Growth of money supply (M3) in July – 7.6% and falling from 8.5% in May.

• Growth of credit to private sector in July – 3.4% and falling from 3.5% in May.

• Growth of credit to general government in July – 12.4% and falling from 15.4% in May.

• The employment is short of more than two million than before the pandemic, especially among the younger and lower skilled. The number of workers in job retention schemes also remains substantial.

• The third series of targeted longer-term refinancing operations (TLTRO III) remains an attractive source of funding for banks, supporting bank lending to firms and households.

• Many firms and households have taken on more debt during the pandemic. Therefore, any deterioration in the economic outlook could threaten their financial health which in turn would worsen the quality of banks’ balance sheets. Therefore, policy support remains essential to prevent balance sheet stresses and tightening financing conditions.

• To support the recovery, ambitious, targeted and coordinated fiscal policy should continue to complement monetary policy.

Learning Outcome

• Unlike the US with active financial markets, the Euro area is largely bank intermediation-based and, therefore, ECB’s lending to banks under refinancing programmes plays a key role.

• As part of promotion of bank lending, ECB’s deposit facility rate has been maintained at negative 0.50% to encourage banks to lend their excess liquidity created by the ECB’s asset purchases rather than parking it at the ECB deposit facility. Negative interest rate means that ECB charges from banks for their overnight deposits placed at the ECB. Accordingly, banks also charge interest from their deposit customers which encourages depositors to spend rather than deposit at banks.

• The Fed and Bank of England also had lengthy discussions whether to adopt negative interest rates as they also confront excess liquidity in the banking system and parking it with the central bank to earn risk-free interest. Central banks in developing countries who adopt policy interest rates bank overnight bank liquidity-based overnight open market operations in the monetary policy model of developed countries also confront these excess liquidity conditions and paying interest to banks whereas bank lending to private sector is slow and low due to pandemic related risks. This excess liquidity is the first-round effect of money printing under the ultra-loose monetary policies implemented by central banks primarily through lending to governments. Therefore, new liquidity has to be absorbed by the economy through the business of bank lending to promote economic activities in the second round which will take several years, given the credit culture of the economy. In respect of ultra-loose monetary policy adopted for the resolution of the global financial crisis 2007/09, it took more than a decade.

• However, some central banks misinterpret such excess liquidity as potential inflationary pressures that will add to present inflationary build up seen primarily due to supply constraints caused by the pandemic. Therefore, those central banks before economies absorb such liquidity over time have prematurely commenced absorbing such liquidity and tightening the monetary policy under the guise of the control over potential inflation in the future, despite the fact that economies have hardly recovered from the pandemic while new virus variants are spreading and causing greater instabilities and uncertainties on both supply side and demand side. Such policy tightening will raise the cost of credit and cause a liquidity crunch which will lead to a protracted delay in the recovery or stagflation trap.

• However, ECB and other central banks in developed countries consider present inflation rise as transitory and signal that the prevailing ultra-loose monetary policies will continue until the economic recovery is firm even with actual inflation higher than the target (2%).

• Therefore, some analysts propose to raise present inflation targets of 2% to provide for further time and space for fiscal and monetary policies to fight the pandemic without being constrained by the low inflation targets. Present inflation targets have been set before a decade when the countries were at low inflation. However, Corona pandemic has disrupted the global economy and societies since early 2020 and resulting macroeconomic uncertainties and instabilities have caused a considerable disarray of macroeconomic numbers, policies and principles. Further, inflation calculated from consumer price indices in developing countries is highly misleading due to heavily state-controlled markets. Therefore, old inflation targets should not guide or limit the expansionary policy packages for the recovery from the pandemic. Accordingly, the Fed changed its inflation target as average 2% over medium term whereas the ECB changed it as symmetric 2% over medium term.

• Some central banks in developing countries tend to keep interest rates somewhat high above low levels to look after the interests of bank depositor segments with a political bias. However, monetary policy generally aims at credit delivery (loose or tight depending on the contemporary needs of the economy) targeted for spending or aggregate demand in the economy. The ECB and several other central banks maintain negative interest rates policy mainly for this purpose. Therefore, any protection of depositor interests at the time of loose monetary policies must come from the fiscal policy without upsetting the monetary policy.

• Further, some developing country central banks use policy interest rates to promote foreign investments to government securities market and to deal with the balance of payments issues while heavily intervening in exchange rates. For example, if a central bank tightens the monetary policy to control credit for imports and to attract foreign financial market investments to deal with balance of payment problems at the time the economy is running under macroeconomic recession and uncertainties, the prime objective of the monetary policy will be lost. Such other economic objectives must be achieved through fiscal and supervisory instruments as the monetary policy is not the only game in the town.

• The pandemic monetary policy followed generally world over is to raise aggregate demand through credit supported by fiscal stimulus for the only objective of the recovery of economies, supply chains and employment from the historic pandemic recession. In this regard, inflation conditions or price instabilities arising due to supply side constraints also are disregarded. Therefore, bringing other public objectives to the monetary policy prescriptions will only cause ill-management of monetary policy formula and, as a result, the sick will die sooner or later, i.e., economic crisis.

• Therefore, the only monetary policy prescription feasible is the delivery of widespread credit to the government and private sector until the economy reaches a path of sustainable recovery because the current pandemic recession is supply-driven. Taking out the monetary gas or mixing it with other fuels before the recovery will cause protracted stagflation conditions in the economy due to policy mismanagement as nobody has a tested formula for balancing the monetary policy with the fiscal policy (other than technical languages). At this stage, what is only feasible is the policy coordination for expansion of aggregate demand through credit/money creation for the objective of getting the economy out of the recession as fast as possible.

• The present monetary policy model of the control of overnight inter-bank interest rates and liquidity through short-term open market operations (followed from the US model) does not work the developing countries as it does not serve wide delivery of credit and liquidity across the economy (private and public sectors) due to primitive credit market conditions. Therefore, the conduit between the overnight banking sector liquidity and liquidity requirements of the economy and its link or transmission to inflation or price stability hardly exists. Therefore, as in the case of the ECB, significant operations of targeted long-term refinancing and asset purchases (government bonds) are necessary as part of the monetary policy instruments. As such, a departure from the conventional text-book monetary models is urgently necessary to deal with these unusual unknown pandemic risks to macro economies (Readers can refer to two books of the author “Innovating central Banks” and “මූල්‍ය ආර්ථික විද්‍යාව: මුදල්, වාණිජ බැංකු සහ මහ බැංකුව,” Sarasavi Bookshop, for detailed discussions).

• Detailed policy communication with forward guidance similar to what followed by the ECB, Fed and other major central banks will be useful to build business confidence and policy credibility in the economy.

(Contents in this article are based on policy communications of the ECB and the author’s hands-on experience on the related subjects)

P. Samarsiri

Former Deputy Governor, Central Bank of Sri Lanka