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Belgium : Calibrating unconventional monetary policy.

The ECBs monetary policy stance is currently driven by three main mutually reinforcing instruments: a negative deposit facility rate; an expanded asset purchase programme covering a broad range of private and public securities (APP); and an integrated system of forward guidance that governs the future path of asset purchases and short-term interest rates, as well as the sequencing of these different policy tools. Moreover, the targeted longer-term refinancing operations, the last of which was conducted in March, will continue to incentivise bank lending over the next four years.

These measures have supported financial conditions, which due to their prominent role in the transmission of policy impulses act as a crucial intermediate variable in the pursuit of a stability-oriented monetary policy. However, while the role of financial conditions in the transmission process has remained as relevant as ever, the task of steering them in line with domestic macroeconomic policy objectives has become more challenging in view of the manifold dislocations in financial markets that have arisen since the crisis and the proximity of standard policy instruments to their lower bound. The ECBs unconventional measures have confronted these challenges and ensured an appropriate degree of accommodation by fostering very favourable financing conditions.

Our monetary policy is working, and we see that, supported by our mutually reinforcing monetary policy measures, the euro area economic recovery is steadily firming. The cyclical recovery is gaining momentum and the expansion is broadening across sectors and countries, showing the effectiveness of the transmission of our measures throughout the entire euro area economy. Yet, the risks to the growth outlook remain tilted to the downside, even though their balance is improving. And, importantly, inflation dynamics continue to be conditional on the present, very substantial degree of monetary accommodation.

In calibrating the set of monetary policy instruments, we faced and we still face two issues. The first, which I will refer to as the measurement issue, consists in quantifying the overall amount of monetary policy support that we are providing and parsing that support down to the individual instruments. In unconventional monetary policy times, measuring the contribution of each instrument to the stance is crucial to ensuring an appropriate composition of the policy toolkit a challenge that is much less pronounced in conventional times when the decision space focuses on policy-controlled short-term interest rates as the one, dominant, tool to steer the stance. Measuring the marginal contributions of each instrument is very hard however.

The second issue, which I will refer to as the benchmarking issue, consists in determining whether the resultant, overall monetary policy support is appropriate, i.e. commensurate with our assessment of the state and expected evolution of the economy; and, if any changes are necessary, what specific instrument in our multi-pronged policy strategy needs to be adjusted. In todays speech, I will review these different challenges and describe the ECBs approach to addressing them.

Measuring and benchmarking monetary policy

To operationalise the intended policy path, it is crucial to form an assessment of the prevailing stance. Here, economists have traditionally resorted to two types of indicators. One consists of policy rules that exploit the systematic relationship between a monetary-policy controlled short-term interest rate, in deviation from some medium-term equilibrium value, and a set of macroeconomic variables, typically including inflation and economic slack as in the eponymous Taylor rule. Given an assumption for the medium-term equilibrium interest rate norm, these rules promise to deliver a level of the short-term rate that would be consistent with driving the economy back to a sustainable non-inflationary path starting from current macroeconomic conditions. The other type of indicator consists of Financial Conditions Indexes (FCIs) that synthesise potentially large numbers of financial variables and weight them based on how well they forecast future (nominal or real) economic activity or how much of the common variation of the individual constituent variables they explain a field to which Jan Hatzius has made important contributions.

The simple benchmarking flavour of the Taylor rule and the broad, encompassing metric of accommodation offered by the FCIs represent a valuable disciplining tool from which one can start to reflect about the prevailing stance and the way the stance should be adjusted as new information flows in. FCIs, in particular, can facilitate story-telling. They have also been able to broadly track the most salient, yet not all, phases of the recent crisis. Overall, they show a positive trend in financial conditions since 2009, reflecting the policy response to the crisis. This was preceded however by a tightening in financial conditions in 2007 and 2008 on the back of investor panic and contagion effects that spilled over across the entire array of asset prices at the height of the crisis. The FCIs also show the subsequent reabsorption that took place in the aftermath of the forceful response by central banks and other policy actors around the globe (see their evolution in the span of time marked by the shaded area for the global financial crisis). Furthermore, they document the renewed tightening in euro area financing conditions that was heralded by the escalation of the sovereign debt crisis in the spring of 2010. More recently, the FCIs point to a clear footprint of the non-standard monetary policy measures the ECB adopted since mid-2014, after the rate cuts over the preceding two years had coincided with broadly unchanged financial conditions.

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Publication:Mena Report
Date:Apr 7, 2017
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