Eurozone growth has stalled and inflation is below the ECB’s definition of price stability. As the recent actions of ECB make clear, further monetary easing is necessary for the ECB to fulfil its mandate.
Unfortunately, the actions taken so far are insufficient, and run the risk of depressing sentiment. There is no point in further debate over negative interest rates. We don’t have enough empirical evidence one way or the other, but the verdict of financial markets is relatively clear. Equities and banking stocks are cyclical risk assets and they are responding poorly to negative interest rates. The logic is straightforward. There is no reason to believe that the economic response to falling interest rates is linear and has a fixed sign. If rates are high and are reduced, it is more likely to be a stimulus, as they approach or pass through zero in economies with high private sector savings, high income per capita, and ageing populations, it is just as likely that the effects are to depress demand.
This by no means renders monetary policy redundant, it just requires are important change in tactics. In fact the ECB – through brilliant innovation – has shown how to do it: dual interest rates. If there are dual interest rates, negative rates will always work. (In this regard, Miles Kimball and I are in agreement).
How? Consider the simplest example. Let’s say everyone banks with the central bank, and there is an equal number of borrowers and depositors. There are two interest rates, a deposit rate and a borrowing rate. Both are variable. Is it an economic stimulus if the central bank raises the deposit rate, say 50bps, and cuts the rate on loans by 100bps? Of course it is, always, and under any economic model: savers and borrowers both experience an increase in disposable income. The only issue is the magnitude of the stimulus.
Ok, so how does the ECB do this? Fortunately, it already has the tools, but is being somewhat sheepish in their application. The ECB’s refi and deposit rates influence Euro money market interest rates rates, which affect deposit rates across the Eurozone, and the lending rate is the interest rate on TLTROs. This is why TLTROs are the most significant monetary innovation since the financial crisis. They can always work, and in contrast to QE, their marginal effectiveness can increase.
What are TLTROs? TLTROs are loans from the ECB to banks which are ‘targeted’, another words the ECB monitors and restricts the use of the funds. The interest rate on the TLTRO is set independently, but with reference to the deposit rate. It would be simplest to free it entirely, or alternately to set it at a negative rate relative to the deposit rate the ECB pays on bank reserves.
So here is what the ECB should do: It should announce a new 10-year TLTRO equivalent to €1trn, at a fixed negative interest rate of 1.5%, and it should simultaneously raise the deposit rate to 0%. In order to offset any potential deterioration in the terms on outstanding TLTROs it can also offer to refinance these on existing collateral and maturity terms, but also reduce the interest rate to a fixed -1.5%. If further stimulus is required, the ECB can completely relax collateral requirements on these TLTROs. These funds should be available for any form of household borrowing (including mortgages which are oddly excluded currently), and any form of new corporate investment spending.
This is an unambiguous monetary stimulus, the only question is whether or not it is large enough. But its efficacy is easy to test. First, watch the response of cyclical assets. If equity markets rise, which I have no doubt they will, the policy measures have a positive sign – and so too will bank stocks. Second, watch demand. If the response is weak, do more. The ECB now has three axes on on which to ease monetary policy – the interest rate on TLTROs, the term of the loans, and the collateral. It should announce a willingness to use all until its price stability mandate is reached.
There are only two objections to this policy. The most serious is that the ECB is getting involved in directed lending. Well, TLTROs already exist. There has been no significant legal objection to TLTROs, in contrast to the SMP or QE programmes, and they have been designed to serve monetary policy purposes. Other than a restriction that the funds be used for new lending to households and business investment, there should be no restrictions. These requirements can easily be defended as the purpose and function of monetary easing. The ECB could also suggest that the European Parliament vote endorsing its actions – this is not a legal requirement, but would be a suitable response to recent concerns about ‘democratic legitimacy’ – the ECB has complete legal freedom to meet its inflation mandate as long as it does not finance fiscal authorities.
The second objection is spurious, but worth pre-empting, which is that the ECB will ‘lose money’, and see a reduction in accounting equity. The irrelevance of this objection has been covered in detail, but it has a habit of resurfacing. Suffice it to say that the losses are likely lower than under successful QE.
In conclusion, the current fashion for monetary apathy is misguided, and dangerous. There should be widespread calls for the ECB to do its job. It has the tools. Now it should get on with it.