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Frankfurt am Main | 15.09.2017

Weidmann: do not miss the right time for monetary policy normalisation

Jens Weidmann at the Institute for Monetary and Financial Stability [+] Bundesbank President Jens Weidmann believes that the Governing Council of the European Central Bank (ECB) should make sure that it does not miss the right time for monetary policy normalisation. "Precisely because the monetary conditions will continue to support economic activity for a long time to come, the question arises as to how much room for manoeuvre monetary policymakers will still have when the next downturn comes along," he said in a speech delivered before the Institute for Monetary and Financial Stability of the University of Frankfurt.

However, according to Weidmann, given subdued inflationary pressure, an accommodative monetary policy stance remains appropriate in the euro area, though he added that "[o]pinions can, admittedly, differ with regard to how much we should step on the pedal in terms of monetary policy and what instruments ought to be used for that."

Monetary policy will continue to support economic activity

Weidmann emphasised that, even after the net purchases under the asset purchase programme have been discontinued, euro-area monetary policy would remain extremely accommodative. He noted that what was crucial for the degree of expansion in monetary policy was not so much the amount of monthly purchases but, above all, the total outstanding volume of sovereign bonds on central banks’ books. In addition, the amount held by the Eurosystem would remain at a very high level even following the discontinuation of net purchases, given that the Governing Council of the ECB has adopted a reinvestment policy in which maturing bonds are replaced with newly issued bonds.

Given the large number of problems this entails, the Bundesbank President regards government bond purchases purely as an instrument of last resort in order, for instance, to stave off a dangerous deflationary downward spiral of declining prices and wages. "But I’ve said in the past that the fears of deflation are overblown," he said, adding that "now they have very largely disappeared".

According to the ECB’s latest staff projection, euro-area inflationary pressures remain subdued, with ECB economists expecting an inflation rate of 1.2% in 2018 and 1.5% in 2019. "The domestic price pressures identified in the projection are quite consistent with a path towards our definition of price stability." The ECB Governing Council has defined price stability as a year-on-year increase in consumer prices of below, but close to, 2%.

Monetary policy influences risk appetite

In his remarks, Weidmann also discussed the role of monetary policy in safeguarding financial stability. "Monetary policy can influence financial players’ willingness to take risks," he noted, adding that it also influenced banks’ propensity to run risks in another, unintentional way: "[t]he more a central bank protects banks against potential risks and promises them central bank funding if the worst comes to the worst, the less wary they will be to take on excessive risk."

However, the Bundesbank President sees pitfalls for monetary policy in making financial stability an explicit objective as well, potentially on a par with the objective of price stability. "[T]he more objectives monetary policy pursues, the more likely monetary policy could get caught up in a conflict of objectives and be forced to weigh up one objective against another. That could not only put monetary policy under greater political pressure, it might also give the impression that monetary policy is arbitrary."

Hammer and scalpel

Weidmann sees macroprudential policy as the first line of defence against risks to financial stability. Their instruments – such as countercyclical capital buffers or caps on loan-to-value or loan-to-income – can be deployed much more precisely than monetary policy. "So where monetary policy is the hammer in a central bank’s toolkit in relation to financial stability, macroprudential instruments are the scalpel." This simile is particularly apt in the case of the euro area, where unsound national developments cannot be addressed by means of the single monetary policy.

Monetary policy must keep longer-term developments in mind

Yet at the same time Weidmann emphasised that, even for monetary policy that focuses exclusively on the objective of price stability, it could be potentially advisable to take financial market developments into account. "As we recently had the misfortune of observing, financial crisis have a considerable impact on the monetary policy transmission process and monetary policymakers’ ability to ensure price stability." This is why monetary policy must not look on idly if, for instance, excessive credit growth stands to jeopardise longer-term price stability. According to Weidmann, monetary and credit aggregates are good indicators of financial imbalances, as has been shown by numerous studies as well as by the history of the recent crisis. That is why, in his view, the second, monetary pillar of the Eurosystem’s monetary policy strategy has lost none of its importance.

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