Returning to monetary policy normality is a challenge

he European monetary authorities have used conventional as well as unconventional monetary policy measures to counter the knock-on effects of the financial and debt crisis in recent years. However, it is now becoming increasingly clear that the monetary policy toolbox is virtually empty – as evidenced by the fact that the European monetary authorities are being increasingly forceful in urging various Eurozone countries to implement reforms.

Should the clouds on the economic horizon darken further over coming weeks and months, the monetary authorities are at first likely to adjust their current forward guidance for key interest rates. If inflation remains at a low level, the monetary authorities are likely to abandon the idea of a hike in key interest rates. To clarify this position, the ECB could once again highlight in its monetary policy statement that key rates will probably remain at their present levels for an extended period of time.

An extension of the APP reinvestment period would probably be one way in which the ECB could ease the monetary policy framework a little further. The central bank remains a substantial purchaser of government bonds even after the end of net new purchases. To limit the upside scope for longer-term capital market yields on a lasting basis, it is quite conceivable that the ECB will spell out and at the same time extend the time horizon for reinvestment. This would probably help yields to remain low for some time yet. But in order to provide an additional monetary policy stimulus, the central bank would probably need to promise a very lengthy reinvestment period (in excess of five years).

In the event of an economic shock, the ECB representatives are very likely to consider resuming the recently ended monthly bond purchases (net new) under the APP in order to pump further central bank liquidity into the financial markets. At the same time, however, the central bank chiefs are also likely to be aware that this unconventional instrument no longer has the same impact as it did when it was introduced in 2015. In the event of a revival of monthly net new purchases, the issue/issuer limit would therefore be reached comparative quickly for a number of Eurozone countries (Germany, Netherlands, Finland). Evidence of a slowdown in growth could prompt the ECB to consider a liquidity injection in the form of new, longer-term tenders and the continuation of the full allotment policy.

This overview of the remaining courses of action open to the ECB leads to the painful realisation that the monetary authorities have largely used up their monetary policy ammunition in recent years. If the central bank is forced into a further easing of its monetary policy stance should verbal intervention fail, it would probably need to take more radical measures (e.g. abandoning the capital key). However, this would mean it running the risk of damaging its reputation.


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