Unconventional monetary policy leads to harmful side effects

Bundesbank President Jens Weidmann believes that particular caution should be exercised when applying unconventional monetary policy measures. Before an audience of around 300 at the European Banking Congress in Frankfurt am Main, he noted that they "come with a different risk-reward calculus than standard instruments as they have more harmful side effects." Other speakers at the event included the President of the European Central Bank, Mario Draghi.

Weidmann said that, for quite some time now, monetary policymakers in many countries had been fighting for higher inflation and, in the process, applying new, unconventional instruments; in this context, he cited the exceptionally low or, in some cases, even negative interest rates. These moves have made monetary policy the focus of intense political debate. "The intensity reached a level that, at the end of the day, could even have a bearing on the very independence of central banks," the Bundesbank President said, adding that he regarded such independence as a key precondition for a stability-oriented monetary policy.

Temporary factors behind weak price pressure

Weidmann sees a series of temporary factors as being behind the currently weak price pressure in the euro area, which, in his view, are also feeding into long-term inflation expectations, which have remained stable at just under 2%. Between 2012 and 2014, it was the ailing economy that had dampened inflation, as governments and households tried to keep their, in some cases, worryingly high debt levels from mounting even further. "This, too, dampened price pressures," he noted. Weidmann pointed out that, back in 2015, the European Central Bank had already estimated that such domestic factors had lowered core inflation (ie excluding food and energy prices) by up to 1 percentage point relative to the United States. In addition, crude oil prices began a steep decline in 2014; Weidmann sees this as one of the main factors behind the current low inflation. He believes this trend is now in the process of reversing itself: "Inflation in the euro area might rise to 1½% as early as in February next year."

However, although the Bundesbank's president still sees low inflation and low interest rates as the determinants of the current situation, he spoke out against the idea of raising the ECB Governing Council's inflation target in order to increase the monetary policy leeway. The reason he gave was that "changing the definition of price stability could damage the credibility of monetary policy".

Lowering the inflation target is likewise not an option, as this would increase the likelihood of using unconventional monetary policy measures. And at this stage, the side effects of these unconventional policy measures – including negative interest rates – are already being felt by the banking sector in the form of lower profitability. Weidmann said that "monetary policy cannot turn a blind eye if banks' low profitability causes problems for monetary transmission – because, in the future, this could get central banks into trouble with regard to safeguarding price stability."

Politicians hold the key to growth

Weidmann noted that other complications and market distortions caused by the ultra-accommodative monetary policy were already beginning to surface. Sovereign bond purchases were blurring the line between fiscal policy and monetary policy, for instance, and this could ease the pressure on governments to embrace fiscal consolidation. "Unfortunately, these market forces are the only mechanism left to set incentives for sound public finances as the European Commission has basically given up on enforcing the rules of the Stability and Growth Pact," the Bundesbank President said. It is ultimately not central banks that can put the economy on a higher growth path which would also push interest rates back up. "It's politicians who hold the key to unlocking economic growth," Weidmann said. Structural reforms which "the Governing Council [of the ECB] has been tireless in calling for" are necessary.

Draghi: Monetary accommodation still necessary

Weidmann's speech at the conference was preceded by remarks made by Mario Draghi, President of the European Central Bank. Draghi noted that euro-area GDP in 2016 had returned to its pre-crisis level, and that employment had grown by some four million since the crisis year of 2013. Although these were encouraging developments, Draghi still saw a need to preserve the current degree of monetary policy accommodation in the euro area in order to meet the ECB Governing Council's inflation target. He said that the ECB "will continue to act, as warranted, by using all the instruments available within our mandate to secure a sustained convergence of inflation towards a level below, but close to, 2%". According to ECB estimates, the current measures "are expected to raise the inflation rate by more than half a percentage point, on average, over 2016 and 2017".