Futures targeting at the ECB

Geoff Orwell sent me the following:

The idea that monetary policy could use derivative markets to pursue its objectives has appeared in the literature 3) but has very seldom found application. The need to find new tools for the intractable problem of unanchored inflationary expectations could now provide the incentive to test the idea in practice.

The basic idea is that the European Central Bank could offer an option in which it would pay to counterparties in the contract a certain amount of money if the inflation rate was, over a certain period, lower than a certain level, constituting the strike price of the option. Alternatively, or may be in addition, the European Central Bank could intervene in the inflation swap market, offering a fixed rate of inflation against a floating inflation.

Purchasers of the option or counterparties in the swap would make money if the rate of inflation was lower than, say, the ECB objective of 2.00 per cent over a certain period, corresponding to the “medium term” in the inflation objective. This should raise inflation prospects through a number of channels.

In the financial market, the higher inflationary expectations, coupled with cash purchases of securities under QE (or EAPP – Extended Asset Purchase Program as the ECB calls it), would lower the real rate of interest, thus favouring investment. The entry of a big seller of protection against deflation could not only change the expected value of future inflation, but also shift its entire distribution, reversing the unwelcome tendency presented in Chart 1. As a result, the probability of an extended period of deflation – as perceived by market participants – would fall, improving general sentiment and lifting “animal spirits.” In the product market, incentives to postpone purchases for consumption waiting for lower prices would be offset, since consumers could purchase the protection offered by the European Central Bank against too low inflation, thus compensating for the possibility of lower prices. In the labour market, firms could offer higher wages since they would be compensated, if inflation was too low, by the protection offered by the option or the inflation swaps entered with the ECB. Symmetrically workers would demand higher salaries (or would not accept lower salaries): in a way, it would be as if the Phillips curve had shifted up and to the right. Overall there should be a positive effect from a tool that is directly aimed at the problem: too low inflation.

There would also be “political” advantages, since the use of this tool would raise no question of a possible confusion between fiscal and monetary policy, which is indeed an issue, as there would be no obvious link between action in the derivative market and the funding of government deficits. This should be welcome to the ECB hawks, who could see the reliance of the ECB on QE being reduced. . . .

This post was written jointly by Juliusz Jabłecki, head of monetary policy analysis team at the National Bank of Poland (here in personal capacity) and Francesco Papadia. Madalina Norocea provided research assistance.

This is similar to the NGDP futures targeting concept.  Of course we are a long way from actually implementing this sort of plan, but it’s good to finally see central bank officials talking about the idea.  When I proposed negative IOR in early 2009, that also seemed like a crackpot idea.  And speaking of negative IOR, here’s the latest from Benn Steil and Emma Smith (at the Council on Foreign Relations):

Back in 2013, we showed that the ECB’s monetary transmission mechanism had broken down in the crisis-hit periphery countries.  ECB rate cuts were not being passed on to rate cuts on new loans to businesses.

For all the bad news that has come out of Europe since then, it is noteworthy that this mechanism has now been restored in most periphery countries.  In fact, the link between ECB rates and the rates banks charge on new business loans is now, on average, stronger in the periphery than in the core—as can be seen in the graphic above.  (We use the overnight interbank rate as a substitute for the ECB’s policy rate, as it captures both the ECB’s policy rate and the effects of its QE and lending to banks.)

The turning point was the ECB’s June 2014 announcement of a negative deposit rate and cheap long-term loans to banks—known as targeted long-term refinancing operations, or TLTROs. This is because these new measures have disproportionately benefited periphery banks.



8 Responses to “Futures targeting at the ECB”

  1. Gravatar of Gary AndersonAnderson Gary AndersonAnderson
    28. September 2016 at 12:27

    Derivative NGDP futures markets are just more structured finance, and that needs more collateral. So even more bonds would be gobbled up than already exist for collateral. Yields would go down more.

    I don’t know how big that market could become, but the bigger it is, the more bonds would be needed.

    So, if yields continue to decline, that doesn’t bode well for bank profitability as it means the yield curve flattens like a pancake.

    The hoarding is just increasing more and more as people find more uses for bonds, the new gold, or even, the new cash.

    Some central banker just said today that low rates will go on for years. Well of course, structured finance forced the need for bonds beyond anything we have ever seen before.

  2. Gravatar of Lars Christensen Lars Christensen
    28. September 2016 at 20:55

    Scott, this is indeed positive.

    That said, it should be noted that Papadia is no longer with the ECB, but he used to be Director General for Market Operations at ECB.

    The co-author of the blog post is Juliusz Jabłecki who is head of monetary analysis at the Polish central bank (NBP). Poland of course is not a member of the euro zone. Therefore of course could also be interesting to suggest that NBP introduce futures targeting!

  3. Gravatar of Ray Lopez Ray Lopez
    28. September 2016 at 23:08

    Didn’t some exchange have an option on inflation? I recall so, and the volume was light. Like the Case-Shiller product on housing prices, a good idea in theory, but in practice the market largely failed to materialize It’s strange, but perhaps most people don’t want to hedge their real estate for whatever reason, perhaps they still think real estate always goes up (re Case-Shiller) and, for inflation, most people understand intuitively that money is neutral and hence betting on inflation is a random walk. If you want to bet on random walks just bet on exchange rates, as FX markets are well developed.

  4. Gravatar of Larry Larry
    29. September 2016 at 13:25

    I have been operating under the understanding that 2013 growth accelerated in 2013 over 2012. Then someone pointed out this:


    Sorry to be thick.

  5. Gravatar of ssumner ssumner
    29. September 2016 at 14:32

    Lars, Brain freeze on my part, I forgot Poland is outside the euro.

    Larry, Yes lots of people make that comment. I feel like sisyphus–you need Q4 to Q4 growth rates, which accelerated in 2013.

  6. Gravatar of Gary Anderson Gary Anderson
    29. September 2016 at 21:55

    Lars, you posted this in 2012: As the interest rate increases the demand for “bonds” increases and the demand for money drops. https://marketmonetarist.com/2012/01/18/there-is-no-such-thing-as-fiscal-policy/

    But it has been proven, over and over that it doesn’t matter what the interest rate is, bond demand, hoarding of bonds, is massive and yields generally decline. Look at Europe. Negative bonds are selling like hotcakes.

    I say, and market monetarists fail in this, IMO, that massive demand for bonds changes everything. Clearinghouses and derivatives need for collateral turns monetarism on its head.

    It isn’t the fault of the monetarists. It is the fault of the existence and growth of structured finance. The demand for bonds is not talked about much amongst the market monetarists and it must be, because it is why the conundrum continues and will likely continue for years.

    So, there is no such thing as fiscal policy, but there is no such thing as monetary policy either. The New Monetarists are do nothings. Williamson and the Fed do nothing. They have demand for their bonds and that is all they care about.

  7. Gravatar of Ray Lopez Ray Lopez
    29. September 2016 at 23:16

    Sumner: “Larry, Yes lots of people make that comment. I feel like sisyphus–you need Q4 to Q4 growth rates, which accelerated in 2013.” – so you’re basing your ‘no slowdown due to fiscal cliff in 2013’ argument on how one picks the endpoints? If growth really did not slow down, you’d not have to make such artificial arguments.

  8. Gravatar of ssumner ssumner
    30. September 2016 at 11:21

    Ray, Yes, you can pick them to correspond with the austerity, or not. Which would you prefer?

Leave a Reply