Levy, M. (2014) “ECB: An appropriate monetary policy“, VoxEU Organisation, 16 May.
As banks repay their loans from the Long-Term Refinancing Operation, the ECB’s balance sheet is shrinking. This column argues that, given the slow recovery and sustained low inflation, the ECB should replace its bank lending programme with quantitative easing. Buying short-term government debt would be consistent with the ECB’s inflation target, would keep the ECB’s monetary policy separate from its role in bank supervision, and would create a built-in exit strategy from unconventional policy.
Europe’s modest economic recovery and uncomfortably low inflation put the ECB in a bind. Although economic conditions are improving gradually (European Commission 2014), concerns about the potentially negative impacts of deflation persist (Armstrong et al. 2014). The ECB’s top near-term priorities are to avoid deflation (and apparently even sustained low inflation) and extend the economic recovery. It also does not want to extend monetary policy beyond its natural scope and take pressure off EU nations to proceed with economic and regulatory reforms that will lift longer-run potential growth. ECB President Draghi indicated at his press conference at the conclusion of the May Governing Council meeting that the central bank would likely ease monetary policy at its June meeting. An array of alternatives are being considered.
Under current circumstances – in the economy, monetary policy, and banking – I recommend that the ECB announce that it will replace its Long-Term Refinancing Operation bank lending programme with a quantitative easing programme in which it purchases shorter-term sovereign debt. There’s a rationale for this kind of monetary policy. Europe’s growth in aggregate demand is too slow to facilitate healthy real growth and low inflation while accommodating further necessary economic adjustments. The ECB’s balance sheet is shrinking and monetary policy is effectively getting tighter. Commercial bank lending is constrained and the monetary policy channels are clogged. A well-designed QE programme that enhances liquidity and stimulates aggregate demand, but also avoids unnecessary credit policy and involves a predictable exit policy, would be consistent with the ECB’s 2% long-run inflation target.
Relevant posts:
- Wren-Lewis, S. (2014) “Central bank advice on austerity“, Mainly Macro Blog, 05 May.
- Frankel, J. (2014) “The ECB Should Do QE, Mario? Buy US Bonds, Not Eurobonds“, VoxEU Organisation, 24 March.
- Dobbs, R., Lund, S., Koller, T. and Shwayder, A. (2013) “QE and ultra-low interest rates: Distributional effects and risks”, McKinsey Global Institute, Discussion Paper, November.