A Tale of Two Decades of the European Central BankIGIER VISITING STUDENT SIMONE BOLDRINI REPORTS ON A SEMINAR BY MASSIMO ROSTAGNO (ECB), COAUTHOR OF MONETARY POLICY IN TIMES OF CRISIS
An essential task of policymaking is to learn from past experiences. Realizing what was done correctly and what could have been improved is key to more effectively meet future challenges. One example of such learning from experience was offered at the IGIER Policy Seminar of November 8th 2021. Massimo Rostagno (ECB) presented the book “Monetary Policy in Times of Crisis – A Tale of Two Decades of the European Central Bank” written with Carlo Altavilla, Giacomo Carboni, Wolfgang Lemke, Roberto Motto, Arthur Saint Guilhem, and Jonathan Yiangou. Rostagno and his coauthors are economists at the ECB, and the book reflects their systematic effort to take stock from the first twenty years of the European Central Bank (ECB) and draw lessons for the future.
The beginning of the book focuses on how, being a new institution, the ECB had to face the difficult task of establishing its credibility, which is necessary to effectively conduct monetary policy, in an environment anything but friendly. To do so, in 1998 the ECB adopted a strategy centered on a quantitatively precise definition of price stability: inflation rate below 2%. The 2003 strategy review assessed the target and refined it to inflation rate below, but close to, 2%. A seemingly small distinction, but one that has played an important role in shaping market expectations as well as the ability of the ECB to meet the challenges of the coming years.
Indeed, starting from 2008, the ECB had to counter a deep and protracted financial and economic crisis of unprecedented proportion within the remits of its precise price stability definition. This required courage and creativity by ECB policymakers. In these momentous periods, the ECB stood ready to play its quintessential role of lender of last resort. Moreover, it acted to soften the credit crunch by guaranteeing an elastic supply of liquidity through the adoption of the Securities Markets Programme (SMP) and the Outright Monetary Transactions (OMT) program. This period produced another remarkable challenge: the long glide into disinflation that began in late 2012, which was met with innovative and unconventional instruments of monetary policy like the Targeted Longer-Term Refinancing Operations (TLTRO), Negative Interest Rate (NIRP), Forward Guidance (FG), and large-scale Asset Purchase Programme (APP).
The navigation through these historic moments is accompanied by empirical evidence and model-based analysis. The authors make use of two techniques: dynamic stochastic general equilibrium (DSGE) models and Bayesian Vector Autoregressive (BVARs) models. The formers are based on microfoundations and optimization. This guarantees internal coherence but requires one to have confidence on the postulated transmission channels of monetary policy, a condition difficult to meet. Quite the contrary, BVARs rely on minimal identification restrictions, so they offer a good complement to address lack of knowledge about the precise mechanism.
The book was discussed by Ricardo Reis, Professor of Economics at the London School of Economics. His remarks focused mainly on three key aspects of the book narrative: the different definition of price stability that characterized the two regimes of European monetary policy, the role that institutional rigidity might have played in the timing of unconventional monetary policy instruments, and the importance of understanding the impact of different instruments and how they interact. He also remarked that the book missed the discussion on fiscal topics, which played a central role starting from 2012.
In his discussion, Reis highlighted the ultimate goal of the book: to guide us in how we look at past, but also current monetary policy decisions. Indeed, the book is focused on the ideas behind the choices of the ECB throughout its life and how they evolved through time, morphed by new discoveries and new empirical evidence. This knowledge should help us frame and understand announcements that, at a first glance, may seem puzzling.
We are now effectively in a third regime, characterized by a symmetric inflation target. Even though the book might not fully explain the future of monetary policy, it will most definitely help us understand the rationale behind the choices that will lead to these decisions.
The key takeaways of this seminar are thus numerous. First, the role of expectations in pursuing monetary stability, enhanced by the adoption of different precise definitions of price stability. Indeed, the switching to the second regime fundamentally altered the impact of market expectations on inflation. Moreover, the discussants focused on the sometimes-overlooked notion of the medium term. This time horizon allows the ECB the necessary flexibility required to respond to heterogeneous economic shocks that might occur. But most importantly, this seminar and the book taught us an important lesson on transparency and thus accountability of a central bank. We already discussed credibility, but as public institutions, central banks should and must be held accountable to lawmakers and to society. Therefore, central banks should not operate in a vacuum and should not be able to hide their motives behind their decision. Thanks to the work of Rostagno and his coauthors we have now an invaluable tool to investigate the ECB past and future actions. This higher degree of transparency and accountability is necessary to ensure long-term independence and thus the effectiveness of the central bank in the years to come.
by Simone Boldrini