Joachim Nagel ©Frank Rumpenhorst

Nagel: Unusual monetary policy measures justified only in exceptional situations

Bundesbank President Joachim Nagel has cautioned against using monetary policy instruments to limit risk premia. “It is virtually impossible to establish for sure in real time whether or not a widened spread is fundamentally justified,” he said at the Frankfurt Euro Finance Summit. It was certainly plausible that risk premia on the bonds of highly indebted Member States had increased with the announcement of the interest rate reversal, he noted. “Unusual monetary policy measures to combat fragmentation can be justified only in exceptional circumstances and under narrowly-defined conditions.”

The concept of fragmentation

Risk premia on the bonds of highly indebted Member States have increased on the heels of the ECB Governing Council’s announcement of the interest rate reversal. Since then, it has been discussed what, if anything, the ECB should do in order to combat this deviation of Member States’ bond spreads from their fundamentals – a phenomenon known as fragmentation. What exact approach should be taken or how a monetary policy instrument should be designed in detail is still unclear, however. 

In the Bundesbank President’s view, it can therefore only be a clearly defined instrument, which should be activated by the ECB Governing Council based on monetary policy considerations and once three conditions have been met. First, interest rate spreads should be fundamentally unjustified at the observed level. In other words, they are the result of excesses in the financial markets. Second, individual Member States are not receiving the monetary policy signals as intended. In other words, the transmission mechanism is impaired. And third, the above factors are limiting the Eurosystem’s ability to maintain price stability in the euro area. In addition, “it would be crucial for this measure to be strictly temporary,” Nagel continued. 

Instrument would have to be justified solely on monetary policy grounds

According to the Bundesbank President, it is important to ensure that the use of the instrument does not change the monetary policy orientation. “Should this be the case, measures would have to be taken at the same time to neutralise its impact on the orientation of monetary policy,” Nagel explained. To be compatible with the mandate, the instrument would have to be justified solely on monetary policy grounds, comply with the principle of proportionality and contain sufficient guarantees to prevent it from entering into conflict with the ban on monetary financing of governments. “There would also need to be an explanation of what sets the new instrument apart from OMT,” the Bundesbank President argued. The OMT asset purchase programme is subject to clear conditions, and the European Court of Justice and the Federal Constitutional Court have reviewed OMT and found its design to be legal, Nagel said. The final condition, relating to economic incentives, is that it is crucial that Member States continue to have sufficient incentives to conduct their fiscal and economic policies in a sustainable manner and reduce their debt levels. “Effective fiscal conditionality is indispensable in this case,” Nagel remarked.

“Prevent a de-anchoring of inflation expectations”

Mr Nagel also used his speech to discuss the current high inflation rates, which in June hit 8.2% in Germany, according to the flash estimate and measured by the Harmonised Index of Consumer Prices. “A de-anchoring of inflation expectations has to be prevented no matter what,” Nagel stressed. The more tentatively monetary policy acts now, the more it risks getting into a situation where it would need to tighten all the more strongly and abruptly in order to preserve price stability. 

In his speech, the Bundesbank President likened the interest rate steps to be taken by the ECB Governing Council to tighten monetary policy to steps on a staircase. So far, the ECB Governing Council has announced a first increase in key interest rates for the next monetary policy meeting on 21 July and flagged a second step for 8 September. “The number of subsequent steps we will have to climb up the interest rate staircase will depend on the medium-term inflation outlook,” Nagel reasoned. “If this does not improve, a more sizeable interest rate hike would be completely appropriate, in my view. We are assuming that further interest rate steps will follow, and that monetary policy normalisation will continue.” For monetary policy, anchoring medium-term to long-term inflation expectations is critical, Nagel argued, “as it ensures that temporary movements in inflation do not feed into wages and prices and hence become permanent”. Short-term inflation expectations have risen significantly of late. Expert surveys indicate that, while medium-term to long-term inflation expectations have risen, they are still roughly at the target of 2%, Nagel said. 

The ECB Governing Council’s inflation target

In the euro area, it is the job of the Eurosystem – i.e. the European Central Bank (ECB) and the national central banks of the Member States – to maintain price stability. The ECB Governing Council, of which the Bundesbank President is also a member, considers that price stability is best maintained by aiming for a 2% inflation rate over the medium term. Negative and positive deviations in the medium-term inflation outlook are considered to be equally undesirable. One reason why the word “medium-term” is so important is that short-lived deviations from this target are unavoidable and also do not necessarily require a monetary policy response. It is far more crucial for monetary policy that medium and long-term inflation expectations are firmly anchored at the target level of 2%. According to Eurosystem staff macroeconomic projections from the beginning of June, euro area consumer price inflation is set to average 6.8% for 2022 and 3.5% in 2023. And in 2024, the average inflation rate is projected to still be slightly in excess of the 2% inflation target.