Central banks: price inflation stabilizes interest rates

In an economic crisis, traditional monetary policy instruments may be ineffective. Although the central bank has already lowered its key rates significantly by placing them at levels very close to 0% (then we are talking about the lower bound of zero), it may face two challenges:

  • inflation remains consistently below the target of the central bank, and inflation expectations, economic agents’ forecasts of price dynamics in the coming years are also below the target. At worst, deflation can threaten the economy, leading to a deflationary spiral that is very difficult to escape;
  • financial institutions do not pass on the reduction in key interest rates to the real economy through lending, thus preventing demand stimulation by inflationary economic agents.

In these two cases, the central bank must resort to other instruments to implement monetary policy. We will define four non-standard tools.

By increasing the size of his balance sheet (quantitative easing or quantitative easing), the central bank buys assets en masse in the financial markets including bonds issued mainly by governments. Thus, by supporting the fiscal policy, it directly or indirectly helps to revive the demand and allows the interest rates to fall. Since the launch of its first program after the sovereign debt crisis in October 2014, the ECB has bought around €3.260 billion in assets. To this should be added €1,700 billion in purchases in response to the Covid-19 crisis.

However, this tool calls into question the independence of the central bank that finances fiscal policy (and budget). However, with inflation below the central bank’s target, the central bank remains consistent with its mandate. Thus, in a crisis, it is normal to have a match between fiscal policy and monetary policy. Moreover, the fact that member states’ bonds are held does not change the ECB’s political independence.

However, maintaining this monetary policy for a long time may cause difficulties. First of all, making the central bank vulnerable to fluctuations in the financial market – effectively assuming risks such as default (“bankruptcy”) – associated with holding bonds. For the second time, this policy may increase the risk taking of the banking sector sees its margins shrink due to lower yields on bonds and loans. Finally, it can help create bubbles in certain financial or real assets.

So can the central bank with qualitative easing (qualitative softening), to change the quality of the collateral it accepts during its operations. During the sovereign debt crisis, financial institutions with risky assets, i.e. with a high probability of default, cannot issue new loans, as in the case of Greek government bonds. By converting these assets into liquidity, these institutions can again lend to economic agents.

another tool available to the central bank is the determination of negative interest rates As in Denmark since July 2012, during its refinancing operations. Thus, banks receive a premium when they borrow and encourage lending. As the ECB did from June 2014 to July 2022, negative rates could also apply to fixed deposit facilities: thus making it costly for financial institutions to deposit cash with the central bank, and therefore a strong incentive to fund the real economy is done.

Last resort submitted to the Central Bank to fight inflation based on communication. By providing economic agents with information about future monetary policy, the central bank is better able to lower medium and long-term interest rates. Thus, it becomes more effective in implementing monetary policy. Since July 2013, the ECB has therefore been using forward biasing of interest rates (leading forward) during press conferences.

While the European Central Bank is now struggling with extremely high inflation, this communication still sends a clear signal to economic agents and suggests continued use by the ECB regardless of the economic context. But while there are many tools available to combat very low inflation, The tools to reduce hyperinflation are more limited, indicating the limits of monetary policy.

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