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.

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