Peter Bofinger explains how inflation in the eurozone can be tempered without jeopardizing the recovery.
The explosion in energy prices is increasingly fueling the general evolution of prices. In the euro zone, the core inflation rate (adjusted for energy and unprocessed food prices) almost doubled in the six months to April, rising from 2.1 to 3.9%.
In a recent interview, Isabel Schnabel, Member of the Executive Board of the European Central Bank, indicated a growing desire within the ECB to move away from negative interest rate policy faster than expected. This policy was put in place by the bank’s then president, Mario Draghi, in the summer of 2014 to avoid the risk of deflation and it no longer matches the macroeconomic landscape.
But could such a rise in interest rates stifle the European economy, already heavily weighed down by the lingering effects of the pandemic and the war in Ukraine? Remember that the economic effects of monetary policy are not determined by the nominal interest rate but by the real interest rate (by discounting inflation expectations of the former). Thus, if the ECB were to raise its key rates by half a percentage point now, in line with rising inflation expectations, real interest rates would remain unchanged and still very low.
The main risk in the inevitable adjustment of short-term interest rates is an excessive rise in interest rates on the capital market. Year-to-date, the yield on the ten-year euro benchmark bond has already risen by one percentage point. The expected end of bond purchases by the ECB in the third quarter of 2022 could put additional pressure on the capital market. This would hurt the eurozone’s economic recovery, with potentially magnified effects on bond yields in the most indebted member states, disproportionately affected by rising long-term rates.
It is difficult to assess the extent of this risk. The decisive question is whether the development of interest rates on the capital market should be passively supported by the central bank. In the intensive academic debate on the reasons for the low long-term rates, the view prevails that these are essentially driven by real factors beyond the control of central banks – above all by trends in productivity and demographics as well as investor risk preferences.
A different approach can, however, be found in Joseph Schumpeter’s 1939 book, business cycles. He flatly rejects the notion of an interest rate determined by real factors: “For us, however, there is no real rate of interest…it is the monetary rate which represents the fundamental phenomenon, and the real rate which represents the derived phenomenon.’ This monetary view is supported by a recent analysis by Bianchi, Lettau and Ludvigson, which finds that two-thirds of the decline in real interest rates since the early 1980s can be attributed to regime changes in monetary policy.
The view that long-term interests could and should be actively managed by the central bank goes back to John Maynard Keynes, who wrote in his Currency Treaty“It should not be beyond the power of a central bank (international complications aside) to lower the long-term market interest rate to whatever figure it is itself willing to to buy long-term securities.
In the General theoryKeynes went even further: ‘[A] the central bank’s complex offer to buy and sell at fixed prices gold bonds of all maturities, instead of the single bank rate for short-term bills, is the most important practical improvement that can be brought to the technique of monetary management.’
Yield Curve Control
Keynes’s notion that monetary policy can control not just the short end of the interest rate spectrum, but the entire interest rate structure, has found its way into practical monetary policy. This is called “yield curve control” (YCC).
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This was first practiced in the United States from April 1942 to March 1951. To keep borrowing costs low for the government, the Federal Reserve capped yields at 3/8% for short-term rates and 2.5% for long-term rates. (25 years and over). Inflation rose rapidly in the winter of 1950-51, however, and YCC was halted—against the stated will of the government—via an agreement between the Treasury and the Fed.
Most recently, the Bank of Japan launched the YCC in September 2016, with a target of -0.1% for the short-term rate and around zero% for the long-term. These objectives have not been modified since. A first analysis (the Capstone report) under the direction of Richard Clarida resulted in a balanced, but overall positive judgment.
The Federal Reserve Bank of Australia launched YCC in March 2020, with the aim of keeping the Australian three-year bond yield at 0.25%. In November 2020, the target rate was reduced to 0.10% and a year later it was suspended. In retrospect, the central bank came to the assessment that “the yield target has been effective and supported the recovery of the Australian economy”.
So, at least from a technical point of view, history shows that central banks can directly control long-term interest rates for an extended period. But could YCC apply to the eurozone, where there are only bonds issued by national central banks?
One possible solution would be for the ECB to take its cue from the benchmark ten-year eurozone government bond yield, which is calculated as an average of member states’ bond yields, weighted by their gross domestic products. If it were to manage this rate with bond purchases according to the capital key of the Member States, it could avoid being criticized for unduly financing certain countries. Such an approach would then not require any conditionality.
One may wonder whether it would be wise to set concrete targets for long-term interest rates. It suffices to announce that the ECB will intervene if long-term interest rates become incompatible with the fundamental macroeconomic situation of the euro zone.
In fact, the ECB is already very close to such a monetary approach to long-term interest rates. In an interview with the FinancialTimes in March 2021, ECB Chief Economist Philip Lane said:
[O]Our main objective is to ensure that yield curves, which play an important role in determining general financing conditions, do not outpace the economy. Because, as you know, financial markets are very forward-looking and you may have steepening yield curves that are not conducive to sustaining inflation momentum. It’s really a shift in monetary policy from just focusing on the short-term rate looking at all funding conditions. For many economic decisions, especially in today’s conditions, the longer end also matters.
And Schnabel said in the Handelsblatt interview quoted above: “We will decisively counter any sudden rise in yields that has no fundamental justification.”
From such a perspective, the long-term interest rate is not the result of secular trends in real factors, it is a policy variable targeted by the central bank according to cyclical macroeconomic requirements. This is exactly what, in the General theoryKeynes had in mind (emphasis in original): “If there is such a rate of interest, which is unique and significant, it must be the rate which we might call the neutral interest rate, i.e. the natural rate in the sense above which is consistent full employment, taking into account the other parameters of the system; although this rate can best be described, perhaps, as the optimum rate.’
All in all, it is good news for a frictionless normalization of monetary policy that the ECB does not appear to be leaving capital markets to their own devices. If investors receive the signal that there is an ECB emergency safety net, this should, in the sense of a self-fulfilling prophecy, ultimately require no active intervention by the bank.