15 Apr 2019

“There Will be no Simple and Painless Solutions”

SAFE Policy Lecture: The ECB needs to review its monetary policy strategy, instruments, and theoretical basis, says Lex Hoogduin from Groningen University

Assessing the 20 years of the history of the European Central Bank (ECB), Lex Hoogduin thinks that the greatest achievements of the central bank are two aspects: the ECB was able to maintain price stability until the financial crisis and to restore it until 2012; even more important, the Euro has survived the “biggest financial crisis since the Great Depression”. “That the Euro is still here, is a great achievement of the ECB, and we should not underestimate that”, Hoogduin said in a SAFE Policy Lecture in the House of Finance on 11 April.

Hoogduin, who is a Professor for Complexity and Uncertainty on Financial Markets at the University of Groningen and a former adviser of then ECB President Wim Duisenberg, is convinced that the ECB needs to review formally its monetary policy strategy, instruments, and theoretical basis. “There will be no simple and painless solutions”, he said. According to him, now is an ideal but also critical moment to do this because of the impending appointment of the new ECB president and the upcoming European elections in May. However, Hoogduin said that this is a necessary task for the new president. In this revision, effects of monetary policy on the macroeconomy should be analyzed; it should also be an objective, open review that includes academic insights, Hoogduin said. He pointed out that it is about time for the ECB, as the Fed, the Bank of Canada, or the Riksbank have already revised their monetary strategy or are in the process of doing so.

In the lecture, he talked about the evolution of the monetary strategy of the ECB. He pointed out that the ECB formulated its strategy in 1998 and defined price stability as an annual increase of the Harmonized Index of Consumer Prices (HICP) of below 2 percent in the medium term. On this basis, the ECB formulated a two-pillar strategy: Pillar 1 included a guideline for the annual growth of the broad money supply of 4,5 percent and analysis of monetary developments. Hoogduin argued that pillar 1 was based on the monetarist view that in the long term, inflation ultimately is a monetary phenomenon and that persistently too high growth of the money supply is a risk to price stability. Pillar 2 included a broad macroeconomic analysis of short to medium term real economic developments to assess their implications for price stability. This pillar is based on a New Keynesian framework in which fluctuations in aggregate demand explain changes in the outlook for inflation. Based on the analyses of these two pillars, the ECB Governing Council assesses the overall risks to price stability and derives the monetary policy stance. “This strategy was a compromise between two theoretical views and represented also a political compromise”, Hoogduin said.

Cohesion in the governing council is undermined

It was also unique, as, at that time, most central banks pursued inflation targeting. Therefore, the ECB was criticized by Anglo-Saxon observers, Hoogduin explained. This lead to a revision of the ECB´s strategy in 2003; from then on, the ECB defined price stability as the annual increase of the HICP below, but close to 2 percent. Hoogduin argued that there were five major changes in the years after the revision. In 2007, the ECB stopped formulating guidelines for money growth; it also pursued strict inflation targeting at 1,8 to 1,9 percent. Furthermore, the core inflation (without prices for food and energy) became more important in the considerations of the ECB. Hoogduin said that the ECB started to give more explicit guidance for the outlook on the monetary policy stance. According to him, the ECB moved from gradualism to a big bang approach in its monetary actions.

Hoogduin sees the current situation of the ECB critical, as it has not been able to achieve the self-set target of price stability in the last five years, despite its unconventional monetary policy like Quantitative Easing and despite a zero interest rate. “The ECB systematically overestimates inflation and unemployment. Its model for understanding the inflation process does not work”, he said. Hoogduin also argued that the cohesion in the governing council is undermined with persistent opposing views; according to him, there is a lack of a joint philosophy behind the monetary policy.

He also pointed to the negative impact of the monetary policy of the ECB, which, for example, puts pressure on savers, pension funds or life insurance companies. In his view, the monetary policy causes bubbles in asset and housing markets. He warned that it is also causing moral hazard problems because it is shielding countries from markets pressures, postponing or avoiding necessary adjustments in competitiveness. Furthermore, Hoogduin argued that the ECB has no adequate instruments to cope with the next recession.

Hoogduin concluded that a new president has to start a comprehensive review process of strategy and instruments. “This should be a standard process, whenever a new president starts”, he said. He also said that a new president and new board members should come from the outside the central bank. Hoogduin named two candidates who would in his view be suitable for the position at the top of the ECB: Vitor Gaspar from Portugal (Director Fiscal Affair Department at the International Monetary Fund, IMF), and Jose Vinals from Spain (formerly IMF, currently Group Chairman of Standard Chartered). In Hoogduin´s view, both are capable of leading the ECB but also have the distance needed.

Video of the SAFE Policy Lecture with Lex Hoogduin: A Critical Assessment of ECB Monetary Strategy and Policy