In recent weeks, the European Central Bank (ECB) has talked openly about helicopter money, price-level targeting and debt monetization. None of these are imminent. But against a backdrop of high debt and weak growth, further steps into experimental monetary policy terrain look inevitable.
So great was the confusion caused by mixed messaging at the March ECB press conference that markets overlooked some revealing comments made by President Mario Draghi. Subjects once thought taboo are now being openly discussed. Longer term, they’re likely to far more significant than the current level of the lower bound for euro-area interest rates.
At one point during the press conference, Draghi was asked about helicopter money—central-bank financed fiscal stimulus. He called it an interesting “concept,” but added that the ECB hadn’t discussed the idea and that it would present legal and accounting “complexities.” As helicopter money would probably breach the ban on monetary financing in the European Union Treaty, we find this a surprisingly neutral response.
In a subsequent newspaper interview, Draghi claimed that ECB research showed that “too low inflation results in redistribution from younger, more indebted households to older households that are typically net creditors.”
We have two problems with this statement.
First, we can’t understand how the ECB could reach such a conclusion. Just as deflation favors creditors, so inflation (of whatever magnitude) favors debtors.
Second, this is just the latest example of the ECB making an explicit link between debt and inflation, and using this to justify ultra-loose monetary policy. In so doing, it’s implicitly putting itself on the side of debtors to the detriment of creditors. In our view, that’s a decision for elected governments—not independent central banks.
The very fact that the ECB is thinking along these lines is important. It highlights how much it’s changed, hints at new priorities and points to a pronounced easing bias for some time to come. Moreover, once a central bank starts thinking in these terms, it might be hard to know where to draw the line? Wouldn’t a higher inflation target be even more beneficial for debtors?
This brings us to our final point. During the press conference, Draghi was also asked whether or not the ECB would ever consider allowing inflation to overshoot its target for a while in order to compensate for the persistent undershoot of recent years. After some hesitation, he responded by saying that “we’ll have to define the medium term in a way that, if the inflation rate was for a long time below 2%, it will be above 2% for some time.”
Putting aside the mechanics of how the ECB would actually achieve this feat when it hasn’t been able to hit a 2% target, this approach sounds very much like price-level targeting. That would be a radical step. In theory, price-level targeting is an alternative to lower interest rates when they’ve reached the lower bound—the idea is to drive real rates down by driving inflation expectations up. In practice, though, no country (to our knowledge) has formally adopted this approach since Sweden in the 1930s.
Price-level targeting is also dependent upon the central bank being able to control inflation expectations in a way that might work in textbooks and macroeconomic models, but might prove difficult to replicate in the real world.
While interesting in theory, we doubt that price-level targeting would be effective in the euro area. Nor do we think the ECB will adopt it any time soon.
Nonetheless, Draghi’s comments provide an important insight into the type of thinking that is likely to shape the future direction of monetary policy in the euro area. In light of this, we should be prepared for even looser monetary policy and further steps into uncharted, unconventional territory.
Moreover, the ECB’s increasingly frequent references to debt when talking about the need to lift inflation back to target suggest that it knows it can’t be a passive player in the deleveraging process. When debt is high and growth weak, the central bank is always likely to be a part of the solution.
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