A new 2 pillar strategy for ECB

ECB’s two pillar strategy and the officers of ECB’s defense for the same is well-known. The two pillars are Monetary pillar and Economics pillar. Here is an interesting anecdote on how ECB got the two pillars strategy.

Daniel Gros and Paul De Grauwe suggest it is time for a change in the two pillar strategy.

The ECB has been arguing in the past that since there is no trade-off between price stability and financial stability, the pursuit of price stability is the best a central bank can do to also maintain financial stability.

We argue that there is a potential trade-off between price stability and financial stability. In order to make this trade-off less constraining we propose that the two-pillar strategy of the ECB should be reformed. In this new two-pillar strategy, the ECB should pursue two objectives, i.e. price stability and financial stability. In this new strategy the interest rate should be used to achieve the inflation objective, while other instruments (minimum reserve requirements and macro prudential control) should be used to achieve financial stability.

The authors explain how exclusive focus on price stability could lead to financial instability. They explain this using two methods – one when ECB lowers rates to take care of supply shock (like technology). Two, when animal spirits first leads to an increase in supply and then a shift in demand.

In both cases, price stability is achieved but financial instability builds in. In first case, the policy stimulus leads to asset bubbles and in second bubbles start building early on because of animal spirits. Read the paper for better explanation.

How to measure financial stability?

  • The authors point that by looking at asset prices and credit growth we can look at financial stability

How can ECB manage financial stability?

  • Two tools- reserve requirements on banks and macroprudential tools. ECB already has powers to use reserve requirements but ahs kept it unchanged at 2% since inception. The authors  say during excessive credit growth the ratio should be raised.

The authors thus suggest ECB could have these two pillars- price stability for which they have interest rates and fin stability for which reserve requirements and macroprudential tools would work.

Thus the ECB could have applied such a separation during the period 2003-07. This would have allowed it to set the interest rate as its privileged instrument to keep inflation within the target zone. At the same time, observing that bank credit was increasing in an unsustainable way and that this coincided with several bubbles in asset markets, the ECB could have increased the minimum reserve requirements, lowered the loan-to-value ratio, and imposed lower leverage ratios on systemic banks.

There is little doubt that this would have reduced the expansion of bank credit during that period. Since a large part of the expansion of bank credit was channelled into asset markets (including housing markets) this would also have reduced the bubbles in these asset markets. The attractive feature of this separation of instruments is that the ECB could have achieved this without the need to raise the interest rate. This is an important advantage, because the use of the interest rate to counter asset bubbles encounters a lot of political opposition and criticism.

The authors answer one puzzle which has bugged me for a while. ECB officials actually have said in numerous speeches that monetary pillar which includes tracking both monetary and credit developments has been very useful (see this Stark speech). They ask central banks to go back to basics and track monetary developments. So how did they miss the fin stability bus?

The authors point that both credit and money supply growth was higher than ECB targets:

It will be remembered that in its initial monetary policy strategy, the ECB had set the growth rate of M3 as a reference value (intermediate target) for guiding the economy towards price stability. It is clear that this strategy has failed, as can be seen from Figure 5. We observe that the growth rate of M3 by far exceeded the reference value of 4.5% which was the number the ECB announced to be the maximum that should not be exceeded if the inflation target of 2% is to be achieved. The facts are that the ECB came very close to achieving its inflation objective during 1999-2008 (it was 2.2% on average per year) while the growth rate of M3 wildly exceeded the 4.5% benchmark (it was 7.4% on average per year).

Hmm…so money supply did not effect inflation and ECB was ok with the money growth. So where did money supply go?

The failure to control the growth rate of monetary and credit aggregates, while inflation was very close to the objective of 2%, is related to the phenomenon documented earlier, i.e. the excessive expansion of bank credit that was channelled mainly into asset markets, while leaving goods markets relatively unaffected.

Hmm. the authors claim that bulk of the growth in money and credit went into asset markets and not goods markets. So inflation was not affected but financial stability went into a toss. Interesting explanation.

Good insights. As usual Paul de Gruawe makes a lot of sense.

Read the whole  thing

2 Responses to “A new 2 pillar strategy for ECB”

  1. Credit booms gone bust « Mostly Economics Says:

    […] is what Paul De Gruawe et al also say in their paper on ECB strategy. The increase in money supply did not show in inflation as much of it was going in credit and […]

  2. Money Supply, Credit Expansion, and Housing Price Inflation « Mostly Economics Says:

    […] rise in inflation. But does show rise in house prices or asset prices. This is what is also said by Paul De Gruawe on why ECB needs an alternate strategy and in this superb paper by Taylor-Schularik which looks the same relationship across many […]

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