European Central Bank president Jean-Claude Trichet was pretty sharp to Chatham House attendees on Monday this week, declaring in his keynote address on the ECB’s response to the financial crisis, that:
As for possible additional non-standard measures in the future, I will stick to what I said at my last press conference: The Governing Council will take any new decision on 7 May. At this stage we have agreed not to give any further indications but will, on that day, provide all the necessary information on anything that is decided.
Très mysterieux Monsieur Trichet. And if that wasn’t enough intrigue for you, then witness this speech, by the ECB’s Lorenzo Bini Smaghi, on conventional and unconventional central bank measures, which is full of hints of what the ECB, or at least one of its executive members, might be thinking when it comes to quantitative easing. Before we go into any detail though, we should include Bini Smaghi’s own disclaimer:
As you might know, the ECB Governing Council will be discussing and taking decisions on the use of unconventional measures on 7 May. My remarks here today, made on a strictly personal basis, in no way prejudge those decisions. Both my visit here and the subject of my lecture were arranged some time ago. My intention today is to offer a rationale for such measures, not to pre-announce them.
Bini Smaghi gives a sophisticated rundown of the types of unconventional policy measures available to central banks, summarised (very quicky) below:
- Direct quantitative easing involving the purchase of longer-term government bonds from banks. The banks can use the additional liquidity to extend new credit — a weakness in the approach since banks can still choose whether or not to use that liquidity to make new loans.
- Direct credit easing involving the purchase of commercial paper, corporate bonds and asset-backed securities. The effectiveness of this measure, which is aimed at wholesale financial markets, depends on their importance in the financing of households and firms, which varies considerably from country to country, according to Bini Smaghi, who notes that is is also much lower in the Euro area than in the US. But he also says that it’s a more attractive strategy in times of acute bank distress, for obvious reasons.
- Indirect (endogenous) quantitative/credit easing involves central banks lending to normal banks at longer maturities, against collateral like assets. That way the central banks don’t have to directly hold the assets, and increase the risk on their balance sheets. This is something the ECB is already doing.
There’s a host of moral hazard and EU-specific technical issues in the above, notes Bini Smaghi, not least the difficulty of coming up with an effective exit strategy. Any of the above unconventional measures, therefore, need to really be justified by the economic situation. So, when exactly do central banks know they need to pursue one or all or a combination of the above options? This is Bini Smaghi’s summary, from his conclusion:
To conclude, the decision whether to embark on non-conventional monetary policy measures, which specific ones and for how long depends on a series of considerations, including the overall conditions of the economy, in particular the presence of deflationary pressures and the effective constraint provided by the zero lower bound for interest rates, the structure of the financial flows in the economy, the medium term incentives that would be created for the private sector and the risks entailed in the exit strategy, including for the independence and credibility of the central bank. Some measures present greater advantages, in terms of providing the right incentives and being easily reversible. Others present more risks and have to be well targeted and used under specific circumstances. Considering the pros and cons of the various measures requires deep thinking. I have tried to develop tonight some of the considerations underlying such a reflection. Hopefully this has been useful in understanding why the ECB has proceeded speedily in some areas while taking the necessary time to reflect on others.
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On the deflationary point — which we think is the most important for the ECB when it comes to unconventional policy measures — much of the central bank’s decision will depend on the use of its own models for predicting deflationary and inflationary risks. JP Morgan’s Western Europe economist David Mackie has a thing for models (the financial kind), and does a good job mimicking the ECB’s own. Here’s his take:
The ECB has two key ways of shaping its medium-term view of inflation: first, a Phillips curve embedded in a standard macro model provides a modal expectation for the inflation outlook; and second, a set of bivariate time series models creates a sense of the risks around the modal outlook …
Firstly, then, on the Phillips curve:
We are not able to mimic the Phillips curve embedded in the ECB’s macro model. Nevertheless, we have our own Phillips curve that does a very good job of explaining movements in core inflation … If we assume that the exchange rate is stable over time, then the current level of capacity utilization is estimated to depress the year on year measure of core inflation 1.1%pts. Because the model is an accelerationist Phillips curve, this downward pressure on inflation persists for as long as capacity utilization is below its equilibrium. With the likelihood that the current deep recession will be followed by a lackluster recovery, there is a real possibility that core inflation will turn negative. Our actual forecast doesn’t go this far, reflecting some stickiness in the inflation process as the level moves toward zero. Nevertheless, any inflation model with a significant role for slack will generate a forecast for core inflation close to zero in the coming years.
Secondly on the bivariate models:
The ECB’s decisions on monetary policy are influenced not only by the modal projection of inflation but also by the central bank’s perception of the distribution of risks. The ECB forms a view of the distribution of risks by looking at the output of a large number of bivariate time series models, which project inflation on an 18-month horizon using past information on inflation itself and one additional factor in each regression. These additional factors include monetary, financial, commodity price, and real economy indicators. Last year, we mimicked the ECB’s methodology to highlight the central bank’s perception of upside risks to inflation. We have now updated that analysis to gauge a sense of the central bank’s view of downside risks.
The significant drop of inflation itself in recent months, and the movement in the additional regressors, suggests that both headline and core inflation will drop significantly on an 18-month horizon. Considering headline inflation, the average prediction of the bivariate time series models for September 2010 is 0.7%oya, well below the ECB’s definition of price stability. The range extends from -0.7% to 1.7%. If we take 1.9% as the ECB’s definition of price stability, all of the models predict that headline inflation will be below that level on an 18-month horizon, and 11 of the 14 models predict headline inflation below 1%. Only 1 of the models, however, predicts outright deflation. Considering core inflation, the average forecast for September 2010 is 1.2%oya, with a range from -0.8% to 2.3%. Of the 14 models, 3 predict core inflation above 1.9% on an 18-month horizon, 3 predict core inflation below 1%, and only 1 predicts outright deflation.
If the above seems confusing, it’s because it is. One of the ECB’s models may be indicating a real probability of deflation, while another one is indicating a one in 14 chance. If the ECB was relying purely on its deflation/inflation models it would be confused, but since it’s probably taking into account other factors, like whether banks are actually lending, it’s likely the central bank is still in a tail-spin over what exactly it’s going to announce at its May 7 meeting even as the date is rapidly approaching.
And so are we, to be frank.
Related links:
Conventional and unconventional monetary policy – Lecture by Lorenzo Bini Smaghi (H/T Alea)
Modelling Eurozone GDP – FT Alphaville
QE and the ECB? – FT Alphaville
European capacity collapse: the preview – FT Alphaville