Download publication

Policy Contribution

How should the European Central Bank ‘normalise’ its monetary policy?

During the crisis, the ECB resorted to a number of unconventional monetary tools. This paper discusses how to phase out these policies and what the ‘new normal’ in monetary policy should look like.

By: and Date: November 23, 2017 Topic: European Parliament

This policy contribution was prepared for the Committee on Economic and Monetary Affairs of the European Parliament (ECON) as an input for the Monetary Dialogue of 20 November 2017 between ECON and the President of the ECB.  Copyright remains with the European Parliament at all times

As the global financial crisis unfolded, the European Central Bank (ECB) and other central banks greatly extended their monetary policy toolboxes and adjusted their operational frameworks. These unconventional monetary policies have left central banks with large balance sheets.

As growth picks up in the euro area, there are discussions about how to normalise monetary policy, but it is unclear if normalisation means returning to monetary policy as it was prior to the crisis, or whether there is a ‘new normal’ that would justify different monetary policies.

The debate on the optimal size of the central bank’s balance sheet has not yet been settled. We discuss the benefits and drawbacks of central banks having permanently large balance sheets. It might be difficult to reduce them quickly without negatively affecting financial markets. In order to avoid market volatility, this process needs to be done gradually and preferably passively, by holding to maturity assets purchased during the crisis.

The interest rate – the central banks’ main conventional tool – might stay at a much lower level than historical standards and closer to the zero-lower bound because of a fall in the neutral rate, implying that in the future monetary policy would have to rely more on balance sheet policies and less on interest rate cuts to provide accommodation during recessions.

The combination of these two issues implies that the normalisation of monetary policy will be very slow and entail a long period with a large balance sheet. In the meantime, the ECB will not be able to go back to its pre-crisis operational framework.

In terms of the sequencing of the normalisation process, the experience of the US Federal Reserve, which was one of the first central banks to use unconventional tools during the crisis, could provide useful pointers to the ECB. Following the Fed’s example would involve tapering (ie gradually reducing asset purchases), then increasing key policy rates slowly before reducing passively the size of the balance sheet.

The Fed’s experience shows that the normalisation process needs to be communicated early in order to reduce uncertainty for market participants and avoid any disruption of financial markets. So far, the ECB has been quite successful in smoothly scaling back its asset purchases, but it has not yet provided a clear vision of what its monetary policy or operational framework will look like at the end of the normalisation process.

Read article More on this topic More by this author
 

Podcast

Podcast

Taming inflation?

What are the implications of prolonged inflation?

By: The Sound of Economics Topic: Macroeconomic policy Date: May 25, 2022
Read about event More on this topic
 

Past Event

Past Event

How are crises changing central bank doctrines?

How is monetary policy evolving in the face of recent crises? With central banks taking on new roles, how accountable are they to democratic institutions?

Speakers: Maria Demertzis, Benoît Coeuré, Pervenche Berès, Hans-Helmut Kotz and Athanasios Orphanides Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 11, 2022
Read about event More on this topic
 

Past Event

Past Event

What is in store for Euro area economies?

ECB Executive Board Member Philip Lane discusses the outlook for Euro area economies.

Speakers: Maria Demertzis and Philip Lane Topic: European governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 5, 2022
Read about event More on this topic
 

Past Event

Past Event

Tackling future risks to banks

How to address vulnerabilities in banks in the coming years?

Speakers: Maria Demertzis and Elizabeth McCaul Topic: Banking and capital markets Date: March 29, 2022
Read article More on this topic More by this author
 

Opinion

The week inflation became entrenched

The events that have unfolded since 24 February have solved one dispute: inflation is no longer temporary.

By: Maria Demertzis Topic: Macroeconomic policy Date: March 8, 2022
Read article More on this topic More by this author
 

Opinion

The weakness of average inflation targeting

Introducing average over time without defining what this means is counterproductive and current levels of inflation in the US will sooner or later expose this weakness in the Fed’s new strategy.

By: Maria Demertzis Topic: Macroeconomic policy Date: February 22, 2022
Read article More on this topic More by this author
 

Opinion

Will this be the century of youthful Asia?

Youthful Asia offers immense opportunities for investors, but this potential can only be realised if their infrastructure and energy needs are fulfilled.

By: Alicia García-Herrero Topic: Global economy and trade Date: February 18, 2022
Read article Download PDF More on this topic More by this author
 

External Publication

Book notes: Monetary policy in times of crisis

Review of 'Monetary policy in times of crisis: a tale of two decades of the European Central Bank' published in the Central Banking.

By: Francesco Papadia Topic: Macroeconomic policy Date: February 17, 2022
Read about event More on this topic
 

Past Event

Past Event

A debate on fiscal rules and the new monetary strategy

Presentation of the Yearbook of the Euro 2022.

Speakers: Maria Demertzis, Fernando Fernández, Gonzalo García Andrés, José Carlos García de Quevedo, Pablo Hernández de Cos and Jorge Yzaguirre Topic: European governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: February 17, 2022
Read article More on this topic More by this author
 

Opinion

East-west divergence in central bank action will not last much longer

Fed shift towards raising rates will make it hard for China and Japan not to tighten monetary policy.

By: Alicia García-Herrero Topic: Macroeconomic policy Date: February 16, 2022
Read article More on this topic
 

Blog Post

Venture capital: a new breath of life for European entrepreneurship?

Whether the dynamism of European venture capital of the past two years can be sustained and kick start a credible alternative to bank finance in the European Union remains to be seen.

By: Maria Demertzis and Lionel Guetta-Jeanrenaud Topic: Banking and capital markets Date: February 10, 2022
Read article More by this author
 

Podcast

Podcast

Turkey’s economic struggles

Will inflation continue to surge?

By: The Sound of Economics Topic: Global economy and trade, Macroeconomic policy Date: January 26, 2022
Load more posts