Blog Post

The case for a derivative market programme

The implementation of a Derivative Market Programme could reaffirm the ECB’s credibility and strong commitment to price stability.

By: and Date: March 18, 2020 Topic: Finance & Financial Regulation

In recent years, the European Central Bank has been unable to raise inflation to a level consistent with its price stability objective, defined as close to, but lower than, 2 percent over the medium term. To a greater or smaller extent, this also applies to the central banks of other advanced economies, including the Fed and the Bank of Japan. The ECB’s failure to achieve its goal has not been for want of trying, as it employed forcefully both conventional and unconventional monetary tools to meet its target. The ECB’s desire to reach its target is not only reflected by its actions but also by the forecasts it has made over the last six years, which indicate a strong belief that its policy measures would eventually drive up inflation towards the desired level. However, as Darvas (2018) has shown, the ECB’s forecasts proved to be systematically wrong, with inflation stubbornly clocking in below target (Figure 1). Such repeated failures could drive one to think that the tools in the hands of the central bank are not sufficient to achieve its goal and some out-of-the-box thinking is required.

Source: Zsolt Darvas

Awareness of the increasing cost of unconventional monetary policy has grown. As ECB President Christine Lagarde mentioned in a September 2019 speech, “though the impact of unconventional policies continues to be positive, we need to be mindful about their potential side effects and we have to take the concerns of people seriously. While remaining committed to our price-stability mandate, this requires continuous monitoring.” Very low and negative rates have an adverse impact on bank profits, which are essential if a banking system is to be capable of adequately funding the real economy. In addition, very low rates aggravate financial stability risks, pushing investors towards riskier assets. Quantitative easing (QE), meanwhile, which involves the ECB buying huge amounts of government bonds, blurs beyond the intention of the central bank the border between fiscal and monetary policy. It is also unlikely that, confronted with the COVID-19 crisis, these tools will be sufficient to fend off a recession. The current policy rate is close to the effective lower bound and a large enough cut will be impossible to achieve, while further increasing the intensity of QE might be difficult and limited in its effects.

The failures of the ECB to correctly forecast inflation are linked to muted wage growth, given the increase in euro-area employment, and to weaker than expected pass-through from wages to prices. Seemingly, the channels usually leading to price inflation have been behaving differently than in the past. One potential explanation[1] for these developments is sticky-upwards inflation expectations, causing the relationship between employment and inflation (also referred to as the Phillips Curve) to become unstable. In a sense, we seem to be dealing with a phenomenon that is the opposite of 1970s stagflation, when the Phillips Curve shifted higher and to the right: in recent years, low inflation expectations may have caused a shift of the Phillips Curve down and to the left. Market-based inflation expectations have been dropping since 2012 and are now below the 1.5% mark (Figure 2). Meanwhile, survey-based expectations are also trending downwards, hitting 1.66% in Q1 2020 (Figure 3).

Given these dispiriting developments, we argue that the ECB could intervene in the market for inflation derivatives to drive expectations and actual inflation to a level consistent with its price stability objective.

Source: Bloomberg.

Source: ECB.

Specifically, the ECB could intervene in the inflation-linked swap market, and/or in the market for inflation options, with a dedicated derivatives market programme (DMP). A DMP would work by raising the expected value of future inflation, offsetting the incentives of economic agents to postpone investment and consumption decisions. If the instrument was widely available, firms could offer higher wages, given that the risk of being squeezed between high wages and low prices would be hedged against by buying protection from the ECB through the DMP. When inflation falls below target, firms would be compensated for the extra wage costs by the ECB. The DMP would most likely be self-fulfilling, through its wage-setting mechanism: rising wages would push inflation to the required level without the ECB being called to make payments.

The DMP would effectively provide insurance to economic agents against the ECB’s inability to achieve its self-defined target of price stability. This would raise inflation prospects by addressing the problem directly, rather than working through interest rates and banks. It would also solve some of the problems associated with QE relating to the risk of monetary financing of the budget deficit, and would counter any criticism that the ECB supports profligate spending by peripheral countries.

In current conditions, in which the space to cut nominal interest rates is very limited, an increase in inflationary expectations could provide a welcome reduction in real interest rates, thus imparting a positive monetary easing that would help reduce the negative macroeconomic effects of COVID-19[2].

Some questions still require consideration. None of them, however, looks like a hurdle a resourceful and competent central bank like the ECB could not surpass. One issue would be if derivatives contracts should come for free or should have a positive price. Offering this protection for free, or for a very small price, might be desirable, at least at the start, so the market becomes large enough.

Following from that is the question of whether the market for inflation-linked swaps and options is liquid enough to sustain a DMP. Here two potential scenarios might arise. First, ECB intervention might increase the demand for this type of asset because of the presence of a large player. Second, ECB intervention might crowd out private players, thereby reducing the liquidity of the market.

Another issue to be dealt with is setting the duration of such contracts. Too short a time span would lead the ECB to provide insurance against factors over which it has no control, such as raw material shocks. However, too long a time span would reduce the effectiveness of the tool, as expectations would remain unanchored in the short run. Other questions, such as which inflation measure to use, the cost of losing information because of the bias introduced by the DMP into the market for inflation derivatives, or to what degree a DMP should replace the current interest rate targeting regime, remain open.

Nevertheless, we remain convinced that the implementation of a DMP could reaffirm the ECB’s credibility and strong commitment to price stability. ‘More of the same’ will not enable the ECB to reach its policy goal. The disappointing market reaction to the easing in March 2020 confirms the need to think about potential new tools.  A DMP could be an effective transmission mechanism to the real economy. The situation in the euro area calls for more direct monetary policy action.

This post builds on J. Jablecki and F. Papadia, ‘Can inflation derivatives help the ECB hit its inflation target?’, 13 August 2015.

[1] See also: or


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article More on this topic More by this author



Mythbusters: debunking economic myths

Economics seems to be full of myths that are hard to debunk. Will robots take our jobs? Are trade deficits bad? Is China such a big economy simply because of the size of its population? This week, Nicholas Barrett, Maria Demertzis, Marta Domínguez-Jímenez and Niclas Poitiers put on the detective cap and become Bruegel's own economic mythbusters.

By: The Sound of Economics Topic: Global Economics & Governance Date: April 3, 2020
Read about event More on this topic

Upcoming Event


The Sound of Economics Live: On emerging market crisis with Barry Eichengreen

At this online podcast recording, Guntram Wolff and Barry Eichengreen will discuss the impact of the COVID-19 crisis on emerging economies and the corresponding policy responses.

Speakers: Barry Eichengreen, Giuseppe Porcaro and Guntram B. Wolff Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author


Will the economic strategy work?

Because even thriving companies can be killed in a matter of weeks by a recession of the magnitude now confronting the world, advanced-economy governments have reacted in a remarkably similar fashion to the COVID-19 crisis. But extending liquidity lifelines to private businesses and supporting idled workers assumes a short crisis.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: April 1, 2020
Read article More on this topic More by this author



The macroeconomic policy response to the COVID-19 crisis

From the European Stability Mechanism (ESM) to "coronabonds", the EU seems to be struggling to find an appropriate mechanism to tackle the economic crisis created by the COVID-19 pandemic. What is really the best option? And how do we ensure that, once the pandemic is over, we return to sustainable debt levels and competitive economies? This week, Giuseppe Porcaro is joined by Lucrezia Reichlin, professor of Economics at the London Business School, Grégory Claeys and Guntram Wolff to discuss the macroeconomic policy response to the COVID-19 crisis.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: March 31, 2020
Read article More on this topic More by this author

Blog Post

The fiscal consequences of the pandemic

The likely economic depression triggered by coronavirus will pose a serious fiscal challenge to some euro-area countries. Given the special circumstances of the pandemic, a European solution is needed, involving more European Central Bank purchases, a significantly increased European Stability Mechanism and some degree of mutualisation of the pandemic-related economic costs.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: March 30, 2020
Read article More on this topic


Europe needs a Covid-19 Recovery Programme

Policymakers need to think long-term and start planning a broad investment scheme to reboot the European economy.

By: Grégory Claeys, Simone Tagliapietra and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: March 27, 2020
Read article More on this topic More by this author



How can the EU prevent our economies from shutting down?

From flights cancelled and restaurants closed to companies either slowing or stopping their production, COVID-19 is shutting our economies down. How can the EU reboot them? What should be our fiscal and monetary response to the pandemic? Will our economic system ever be the same once everything is over? This week, Guntram Wolff is joined by Jean Pisani-Ferry and Maria Demertzis to discuss the EU's response to the coronavirus.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: March 18, 2020
Read article More on this topic More by this author

Blog Post

Be bold now: coronavirus, the Eurogroup and fiscal safety nets

This blog post sketches two scenarios: one in which countries provide a large fiscal safety net to companies and another in which they do not. Both lead to similar debt-to-GDP ratios in 2021, but the safety net leads to a smaller and shorter recession and a quicker rebound. We then discuss how to fund a large response without fragmenting the euro area. Until the lockdowns end, such measures should be implemented.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: March 17, 2020
Read article More on this topic More by this author


Why OMT is not the solution for Italy right now

The Outright Monetary Transactions tool is not well suited for Italy right now. Italy needs fiscal support both by itself and by the EU. Italy and the rest of the EU need a fiscal bazooka. We should find a way of backstopping our economies immediately.

By: Maria Demertzis Topic: European Macroeconomics & Governance Date: March 16, 2020
Read article More on this topic More by this author


Only the coronavirus can convince Trump of the virtues of international cooperation

Given how badly the coronavirus outbreak in the US is affecting Trump’s chances to be reelected, let’s hope he comes to its senses and see the advantages of leading a coordinated effort to save the global economy. For once since he came to power, he may see the positive angle of global cooperation and multilateralism, of course, for his own sake.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: March 13, 2020
Read article More on this topic

Blog Post

Gerard Masllorens headshot

The cost of coronavirus in terms of interrupted global value chains

The coronavirus is slowly morphing itself into an important shock. While the extent and cost of this pandemic are unknown, we do know that global supply chains that link Europe to China will be seriously disturbed. We take a look at the numbers based on input-output models. The industry that will be the most affected is Computers and Electronics, followed by textiles.

By: Maria Demertzis and Gerard Masllorens Topic: Global Economics & Governance Date: March 9, 2020
Read article More on this topic More by this author



Is the EU a superpower?

As China and the US battle for global supremacy, the EU seems to remain in the shadows. But what if the EU had been shaping the world economy all along without anybody noticing? Could its soft power be strong enough to shape regulations all over the world? What impact does such influence have over its own economy? This week, Giuseppe Porcaro and Guntram Wolff are joined live by Ashoka Mody, Professor in International Economic Policy at the Princeton University, and Anu Bradford, author of the book "The Brussels Effect: How the European Union rules the world".

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: March 3, 2020
Load more posts