The case for a derivative market programme

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?’ Centralbanking.com, 13 August 2015.

[1] See also: https://www.ecb.europa.eu/pub/economic-bulletin/articles/2019/html/ecb.ebart201904_02~d438b3e4d4.en.html#toc1 or https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1763.en.pdf.

[2] https://wordpress.bruegel.org/2020/03/three-macroeconomic-issues-and-covid-19/.