Chapter 9:Monetary Policy in the Eurozone

De Grauwe:Economics of Monetary Union

Monetary policy when asymmetric shocks occur

• In an optimum currency area few asymmetric shocks occur

• ECB has a relatively easy time to stabilize shocks

• There are few conflicts between member-states and the ECB

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The ECB and asymmetric shocks:policy paralysis

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The ECB and symmetric shocks: stabilisation is possible

Have asymmetric shocks been important in the operation of the Eurosystem since 1999?

Wide range of experiences

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Figure 9.4: Growth of real GDP in the Eurozone

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Figure 9.5: Inflation in the Eurozone

Output gap is a good measures of the business cycle position of countries

•Output growth differences also reflect permanent asymmetric shocks (e.g. productivity growth differences•A measure of temporary shocks (business cycle) is provided by the output gap•We observe large differences •These differences in inflation and output gap experiences lead to different desired interest rates of different countries•We can measure these different desired interest rates using the Taylor rule

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•Wide range of desired interest rates in 2003 (Germany desired interest rate of 1.22%, Ireland desired interest rate of 7.9% •ECB computes average desired interest rate•Many countries are likely to be less than enthusiastic about the interest rate decisions of the ECB

Distribution of desired interest rates and country sizes, Euro-12 (Taylor rule 2005)

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Asymmetric shocks and housing prices

• Large inflation differences within Eurozone• Combined with the same nominal interest rate

in the Eurozone• Create large differences in real interest rates

Large differences in real interest rates in Eurozone

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Figure B17.1: Average real interest rates in Eurozone countries (1997–2005)

Create large differences in house price inflation

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Figure B17.3: Real interest rate and house prices (% change) 1998–2005

The Monetary Policy Strategy of the ECB: a description

• Monetary Policy Strategy (MPS) of ECB consists of two parts:– A definition of the objectives – The instruments to achieve these objectives

The objectives• The Governing Council of the ECB has adopted the

following definition: – ‘price stability shall be defined as a year-on-year increase in

the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%’

• Thus target range of inflation is 0% to 2% • However, recent ‘clarification’: “inflation should remain

below but close to 2%• ‘Medium run’ objective

– The ECB does not define what the ‘medium run’ is

• No mention of other objectives

The instruments

• Two pillars• First pillar: Money stock is reference value

M3 reference value: 4.5%• implicit model:

m + v = p + y

m + v = p + y

m = p* + yf - vf

• Same procedure of Bundesbank

The second pillar

• Second pillar• Other reference values

– Wages– Energy prices– Exchange rate– Yield curve– Possibly other variables

The Monetary Policy Strategy of the ECB: an evaluation

• The selection of the target• Is inflation target of at most 2% too low?• Two-pillar strategy

Selection of the target

• In interpreting its mandate ECB has been influenced by the theory of flexible inflation targeting as developed by Svensson (1996, 2000)

• The central claim made by this theory is that by stabilizing the price level, the central bank also stabilizes the output level

• In this view there is no need to target output explicitly

• Not consistent with mandate set out in Maastricht Treaty

Shocks in aggregate demand and supply

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• When demand shocks occur, inflation targeting stabilizes prices and output

• Not so when supply shocks occur; in this case there is trade-off between output and inflation stabilization

• ECB has made clear that when such a trade-off occur it will choose for inflation stabilization

• Even then gradualism can be applied

Is the inflation target of at most 2% too low?Answer : Yes

1. Rapid technological progress changes the conventional measures of inflation

– The true inflation rate is overestimated by 0.5% to 1.5% a year (quality bias)

2. Some inflation is good for the economy

– It works as a lubricant and allows for more flexible adjustments in real wages

– Argument is based on money illusion

3. Large differences in inflation together with low target pushes inflation in some countries close to zero, possibly below zero

Conclusion on objectives

• 2% maximum inflation rate is too low • The idea of setting a maximum rate is not a

good one – The economy is subjected to shocks – A precise control of the rate of inflation is very

difficult – Setting a maximum rate creates an issue of

credibility

Inflation in Eurozone

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A different target is necessary

• ECB should redefine its target to be a number between 2 to 3%

• Then it should allow some flexibility around this new target in a symmetric way

• This is the approach taken by the Bank of England (target = 2.5%, with some leeway above and below it)

Excessive reliance on the money stock?

• Is money targeting passé?– Measuring the money stock in a world of financial

innovation– Volatility of velocity in new monetary regime– Money stock often gives wrong signals especially

in low inflation environment (see next slide)

• Since May 2003 the ECB has reduced the prominence it gives to the money stock

• Monetary analysis remains important

Inflation and money growth (1970-1999)(average yearly changes)

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Inflation targeting: a model for the ECB?

Instrument Intermediate target Ultimate target

MS-targeting

Inflation-targeting

Interest rate

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Inflation forecast

Inflation

Inflation

•Inflation targeting is superior to money stock targeting (see Svensson (1998)) •The reason is that with inflation targeting the central bank uses information of all the variables (including the money stock) that will affect future inflation•The inflation forecast is then the best possible intermediate target

The instruments of monetary policy in Euroland

Three types of instruments: • Open market operations • Standing facilities (credit lines)• Minimum reserve

1. Open market operations

• Buying and selling of securities with the aim of increasing or reducing money market liquidity

• ECB uses system of tenders, called main refinancing operations

• Governing Council sets the interest rate that will be applied in the main refinancing operations

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• The ECB then announces a tender procedure • This can be a fixed rate or a variable rate

tender – If a fixed rate tender, the interest rate chosen by

the Governing Council is fixed at which financial institutions can make bids

– These bids are collected by the NCBs and centralized by the ECB

– The ECB decides about the total amount to be allotted, and distributes this to the bidding parties pro rata of the size of the bids

• ECB now only uses variable rate tenders

. Interest rate Bank 1 Bank 2 Bank 3 Total bids

Cumulative (%) bids 3.07 0 0

3.06 5 5 10 10

. 3.05 5 5 10 20 3.04 5 5 10 30 3.03 5 5 10 20 50 3.02 5 10 15 30 80 3.01 10 10 15 35 115 3.00 5 5 5 15 130 2.99 5 10 15 145

Total 30 45 70 145 .

. Source: EMI, The Single Monetary Policy in Stage Three, 1997

Table 8.3: Hypothetical example of variable rate tender (million euros)

• Assume that the minimum bid rate set by the Governing Council is 3%

• Three cases:• First, ECB decides to allot 80 million Euros,

then all bids of 3.02% and more are satisfied– The minimum bid rate does not bind

• Second, ECB decides to allot 150 million. – The minimum bid rate is binding. All bids of 3% and

more are accepted (130) – The allotted amount of liquidity (150) is not

exhausted

• Third, ECB decides to allot 120

– There is unsatisfied bidding at the minimum bid rate of 3%

– All bids at 3.01% and more are accepted, and each bank is allotted 1/3 (5/15) of the amounts they bid at the minimum rate

In sum…• Open market operations are the main tools

for the ECB to affect monetary conditions• By increasing or reducing the interest rate on

its main financing operations it affects the market interest rates

• In addition, by changing the size of the allotments it affects the amount of liquidity directly

2. Standing facilities

• These facilities aim to provide and absorb overnight liquidity

• Banks can use the marginal lending facility to obtain overnight liquidity from the NCBs

• The Governing Council fixes the marginal lending rate (1% above the interest rate used in the main financing facility)

• No borrowing limit, provided collateral • The marginal lending rate acts as a ceiling for

the overnight market interest rate

• Banks can use the deposit facility to make overnight deposits

• The Governing Council fixes the interest rate on the deposit facility (1% below the interest rate used in the main financing facility)

• This interest rate acts as a floor for the overnight market interest rate

3. Minimum reserves• By manipulating reserve requirements the

ECB can affect money market conditions • ECB remunerates the minimum reserves• The ECB uses the minimum reserve

requirements as an instrument to smooth short term interest rates

Conclusion• ECB has quite a large range of instruments at

its disposal • As money markets in Euroland integrate

further, the interventions in the money markets will increasingly be centralized