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 about event More on this topic

Upcoming Event


In search of a fitting monetary policy: the ECB's strategy review

The ECB is reviewing its monetary policy strategy. How to ensure monetary policy is fit for purpose in a fast changing world?

Speakers: Maria Demertzis, Philip Lane, Reza Moghadam and Erik F. Nielsen Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article Download PDF

External Publication

European Parliament

Monetary policy in the time of COVID-19, or how uncertainty is here to stay

The COVID-19 crisis has compounded the uncertainty that has come to characterise the European economy. We explore how this uncertainty manifests itself in terms of ECB decision-making and the long-run challenges the ECB faces.

By: Maria Demertzis and Marta Domínguez-Jiménez Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: November 12, 2020
Read article More on this topic More by this author


A tale of two pandemics

The two narratives briefly examined here cast light on different aspects of the EU in the times of Covid-19. Euroskeptic nationalists typically propagate claims of EU failure but have been rather subdued during the pandemic as mainstream governments have taken over their trademark policy of closing borders to foreigners. Nonetheless, the grip on power of several pro-EU mainstream leaders, including President Emmanuel Macron in France, Prime Minister Conte in Italy and Prime Minister Pedro Sanchez in Spain, remains tenuous.

By: Michael Leigh Topic: European Macroeconomics & Governance Date: June 23, 2020
Read article More on this topic More by this author


Reading tea leaves from China’s two sessions: Large monetary and fiscal stimulus and still no growth guarantee

The announcement of a large stimulus without a growth target indicates that China’s recovery is far from complete.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: May 25, 2020
Read article Download PDF More by this author

Policy Contribution

European Parliament

The European Central Bank in the COVID-19 crisis: whatever it takes, within its mandate

To keep the euro-area economy afloat, the European Central Bank has put in place a large number of measures since the beginning of the COVID-19 crisis. This response has triggered fears of a future increase in inflation. However, the ECB's new measures and the resulting increase in the size of its balance sheet, even if it were to be permanent, should not restrict its ability to achieve its price-stability mandate, within its legal obligations.

By: Grégory Claeys Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: May 20, 2020
Read article Download PDF

Policy Brief

Rebooting Europe: a framework for a post COVID-19 economic recovery

COVID-19 has triggered a severe recession and policymakers in European Union countries are providing generous, largely indiscriminate, support to companies. As the recession gets deeper, a more comprehensive strategy is needed. This should be based on four principles: viability of supported entities, fairness, achieving societal goals, and giving society a share in future profits. The effort should be structured around equity and recovery funds with borrowing at EU level.

By: Julia Anderson, Simone Tagliapietra and Guntram B. Wolff Topic: Energy & Climate, European Macroeconomics & Governance Date: May 13, 2020
Read about event More on this topic

Past Event

Past Event

The Sound of Economics Live: The impact of Covid-19 on emerging markets 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 Date: April 28, 2020
Read article More on this topic



Post-Council commentary

On April 23, EU leaders met virtually to try to come to an agreement for a common European response to the COVID-19 pandemic. What were the measures taken? Will they be sufficient? Did Europe come together for a coordinated response to the crisis? Or did the meeting further highlight the cracks between member states? This week, Guntram Wolff and Giuseppe Porcaro are joined by Maria Demertzis and André Sapir to comment on the EU Council meeting.

By: The Sound of Economics and Bruegel Topic: European Macroeconomics & Governance Date: April 24, 2020
Read article More on this topic More by this author


Depression, and not stagflation, could haunt China in 2020

This opinion piece was originally published in Asia Times and Medium China’s GDP in the first quarter of the year has surprised nobody but the devil is in the details. Local retail sales continued to fall in March (-16%), marginally better than during the peak of the Covid19 outbreak in January and February. The continuation […]

By: Alicia García-Herrero Topic: Global Economics & Governance Date: April 17, 2020
Read article More on this topic


The perils of more debt

Europe must find the “Ways and Means”.

By: Maria Demertzis, Nicola Viegi and Bruegel Topic: European Macroeconomics & Governance Date: April 10, 2020
Read article More on this topic



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 and Bruegel Topic: Global Economics & Governance Date: April 3, 2020
Read article More on this topic


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 and Bruegel Topic: European Macroeconomics & Governance Date: April 1, 2020
Load more posts