Orphanides also wonders what happened to the ECB’s monetary pillar

Yesterday the Shadow Open Market Committee (SOMC) held its regular semi-annual meeting in New York.

It is no secret that many of the members of the SOMC have had a large influence on my monetary thinking – just to mention some of them Bennett McCallum, Michael Bordo, Peter Ireland, Marvin Goodfriend and Charles Calomiris all have greatly impacted my thinking.

That said, despite of the fact that the SOMC comes from the same monetarist tradition as myself I must admit I often has a very hard time agreeing with the overall message from the present-day SOMC.

In general I think that the hawkish bias of the SOMC members (and that is a clearly an unjust generalization) is somewhat misguided and seems to me to be overly politicized. I think that is unfortunate because I think that it to some extent overshadows the general message from the SOMC that monetary policy should be rule-based. A view I wholeheartedly agrees with.

That is, however, not really what I want to talk about in this post. Rather I like to highlight a very good paper published in connect yesterday’s SOMC meeting.

The paper – European Headwind: ECB Policy and Fed Normalization – by Athanasios Orphanides in my view is a very good discussion of the monetary causes of the euro crisis. Orphanides of course used to be an ECB insider as Cypriot central bank governor and a member of the ECB’s Governing Council (2008-2012).

What happened to the ECB’s monetary pillar 

At the core of Orphanides’ discussion of the ECB’s failures is a question I often have asked – what have happened to the ECB’s two-pillar strategy and particularly what happened to the the ECB’s M3 target? (See for example here and here).

The entire paper is very good – but I have done a bit of cut-and-paste:

In pursuing its mandate, the ECB adopted a numerical definition of price stability and a two-pillar strategy to guide its monetary policy to attain it. Since May 2003, the ECB has interpreted its primary objective as maintaining inflation rates close to but below 2% per year over the medium term.

This clarified earlier language that had suggested lower inflation levels, explicitly acknowledging the “need for a safety margin to guard against risks of deflation” … Recognition that the operational definition of price stability should be well above zero measured inflation and closer to 2%, in order to account for the zero lower bound on nominal interest rates and provide added room for conventional policy easing, has been a common principle across numerous central banks, including the Fed and the ECB.

The ECB’s two-pillar strategy, as developed under the direction of Otmar Issing who served on the Executive Board of the ECB from the founding of the ECB in 1998 until 2006, provided a role for economic analysis in formulating an assessment of the inflation outlook as well as a prominent role for money and credit as a cross check (Issing, 2005).

The ECB’s two-pillar strategy distilled the fundamental lessons of monetarist economics and combined it with business cycle analysis such as models that  draw on the Keynesian tradition that have generally downplayed the role of money and credit. In this sense, the two-pillar strategy, could deliver more robust policy advice.

…The dismal performance of the euro area coincides with the euro area crisis so it can be suggested that at least part of the responsibility for the outcome (and perhaps the largest part) can be attributed to the mismanagement of the crisis by euro area governments. Pertinent to the ECB, however, would be the question as to whether it has pursued the best possible independent policy action, within its mandate, and accounting for the dysfunction of the governments. And if the ECB has not pursued the best policy to fulfill its mandate, a question of interest is why not?

… according to the monetary pillar, the ECB has pursued consistently exceptionally tight monetary policy over the past few years. Could this be because the monetary pillar lacked information content?

… Before the crisis, real credit growth tracked real GDP growth in the euro area rather closely. And since the beginning of the crisis, fluctuations in real credit growth continue to track fluctuations in real GDP growth…

…The persistent and significant monetary policy tightness reflected in money and credit growth in the euro suggests that the ECB may have all but abandoned its monetary pillar. If it had not, the ECB would have pursued considerably easier monetary policy during this period, counteracting at least part of the dramatic fall in the growth of money and credit. If the ECB has abandoned the two-pillar strategy it had developed over a decade ago, as is strongly suggested by the data, this would represent a very unfortunate development.

…Faster money and credit growth over the past few years could have contributed to higher employment and greater economic growth and stability without compromising price stability. In this manner, faster money and credit growth would have led to better
fulfillment of the ECB’s mandate as specified in the Treaty.

As worrisome as the conclusions suggested by examining the ECB’s monetary pillar may seem, a fundamentally similar conclusion is suggested by examination of recent trends in inflation.

…Over the past six months, core inflation has consistently registered readings under 1%, the first time in the history of the euro with such persistently low core inflation readings. Consistent with the information suggested by the monetary pillar, these data suggest that the ECB has been persistently pursuing overly tight monetary policy. The inflation swap data further suggest that longer-term inflation expectations are becoming unanchored.

(On the ECB “miscalibration” of monetary policy)

…One possibility is a miscalibration of policy at the zero lower bound, perhaps resulting from the misleading notion that policy is already “as easy as can be” once short-term nominal interest rates are close to zero. Such confusion, often associated with the notion of the so called “liquidity trap,” has been noted in earlier historical episodes, for example at the Fed during the Great Depression and at the Bank of Japan in the late 1990s and 2000s.

…History repeated itself across the Pacific during the 1990s. The Bank of Japan was faced with the zero lower bound and stopped easing policy, focusing inappropriately on short-term rates. Economists such as Milton Friedman (1997) and Allan Meltzer (1998)warned that the Bank of Japan should engage in quantitative easing to avert continued stagnation. Friedman reminded policymakers: “There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow; and after another delay, inflation will increase moderately.” Unfortunately, Bank of Japan policymakers delayed the adoption of quantitative easing policies by many years. The result is what we now know as the Japanese “lost decade.”

…The simplest way to calibrate the proper stance of monetary accommodation at the zero lower bound is by adjusting the size of the balance sheet of the central bank through the accumulation of government debt. Once the zero lower bound looms near, policy needs
to shift from interest rates to monetary quantities. Adjusting the size of the balance sheet could replace the traditional movements in the policy rate as a guide to policy. Other options for providing policy accommodation are also available. Clouse et al
(2003) present a review of policy options in a study that was prepared for the FOMC on this issue. In the case of the Fed, the massive expansion of its balance sheet since the beginning of the crisis suggests that in the current episode, the Fed implemented monetary policy along the lines of the policy response suggested by Keynes, Friedman and Meltzer for earlier episodes. The policy response also included additional elements, such as forward guidance, consistent with the preparatory analysis done before the crisis for the

Sadly, in the case of the ECB, the data point to a different conclusion.

… In the summer of 2012, the two balance sheets (of the Fed and the ECB) were comparable, with the Fed’s balance sheet at about 3 trillion dollars and the ECB’s balance sheet at about 3 trillion euro. Since then, the Fed embarked on the quantitative easing policy that has just been concluded at the FOMC’s latest meeting, raising its balance sheet to about 4.5 trillion dollars, an increase of one half. By contrast, over the same time period, the ECB has engineered a massive tightening of policy by reducing its balance sheet to about 2 trillion euro, a reduction of one third.

The tightening of monetary policy that the ECB has engineered through the contraction of its balance sheet has been partly offset by other policy decisions, for example a small reduction in policy rates. Indeed, in response to negative economic developments, in
September 2014 the ECB has undertaken the unprecedented step of bringing the deposit facility rate to minus 0.2%. And the ECB has repeatedly communicated that it wishes to provide the appropriate policy stimulus to fulfill its mandate.

But the very focus on short term interest rates, coupled with the unwillingness to engage in quantitative easing, suggests deep problems with the policy strategy pursued by the ECB in the recent past.

…A central bank claiming that it will do “whatever it takes” while not delivering with actions eventually loses its credibility. Quantitative easing—the expansion of the central bank’s balance sheet through the purchase of government debt—or even the undertaking of open positions in derivatives contracts, allow the central bank to demonstrate with its actions that it means what it says. By “putting its money where its mouth is,” the central bank vastly improves the odds of success in providing policy accommodation.

I find it very hard to disagree with anything in Orphanides’ analysis. In fact it is very similar to my own take on the euro crisis – the ECB consistently has continued to argue that monetary policy is easy in the euro zone, while monetary analysis clearly shows that monetary conditions actually has remained very tight since 2008 and this is the core reason for the crisis and the reason why we are heading for Japanese style deflationary scenario for the euro zone.

But what should the ECB do? Orphanides has a clear policy recommendation:

The most straightforward and time-tested course of action is for the ECB to announce and start the implementation of a quantitative easing program with no further delay. Purchases of euro area sovereign debt should be apportioned according to the ECB’s capital key, to account for the relative sizes of the member states whose sovereign debt would be purchased in the secondary market. How large the purchases should be to restore growth and stability in the euro area, and in full respect of the ECB’s primary mandate, cannot the determined in advance. Judging from the experience of the Federal Reserve, the ECB could announce an initial plan of purchases aiming to double its balance sheet in coming quarters, with a target of reaching at least 4 trillion euro.

This expansion would be proportionally smaller that the expansion of the Fed’s balance sheet relative to size of the balance sheets of the two central banks in the summer of 2012. Nonetheless, a plan to expand the ECB’s balance sheet to 4 trillion euro could serve as a starting point and could be subsequently adjusted, depending on the success of the policy.

One could further hope that the ECB will return to its pre-crisis roots and re-focus on its two-pillar strategy ensuring that money and credit growth in the euro area economy is commensurate with sustainable growth and price stability, in accordance to the ECB’s mandate.

I certainly would fully endorse a programme of quantitative easing with-in a clearly defined rule-based framework and Orphanides suggestion is similar to my own suggestion that the ECB should re-state its M3-target – targeting 10% M3 growth until “money-gap” is closed (See here.) Needless to say I would like to see much more radical reform than that – a full-blown NGDP level targeting regime – but a re-statement of ECB’s monetary pillar and a M3 target would at least provide a much higher degree of nominal stability than is the case today.

However, the sad fact is that it still seems like we are very far away from seeing anything similar to what Orphanides suggests and as a consequence we are still far away to being able to declare an end to the euro crisis. As Orphanides warns:

Europe is not out of the woods and a severe deterioration of the crisis cannot be ruled out, both because of the ECB’s inappropriately tight monetary policy and because of continued political fragility and dysfunction. Turning to this side of the Atlantic, the Fed needs to remain vigilant to headwind from Europe. At the same time, it should be recognized that if the ECB reverses course and adopts the warranted monetary policy for the euro area, global growth prospects would improve notably and the Fed would need to be ready to unwind the accumulated policy accommodation on this side of the Atlantic at a much faster clip than is currently anticipated.

Is anybody in Frankfurt listening? I hope so…

PS see the other SOMC papers here.

Leave a comment


  1. jamesxinxlondon

     /  November 5, 2014

    Fascinating. But, gosh, how people change their tune when in and out of power. I met him soon after he stepped down from the ECB and was shocked by his robust defence of their now increasingly infamous 2011 rate rises. It would be nice to see him admit they were wrong.

  2. J.V. Dubois

     /  November 6, 2014

    Very good blogging. I for once did not know that much about the monetary pillar: which makes “ECB did what they could within their interpretation of mandate” statement even worse.

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