ECB’s Weidmann: Sovereign Debt Buys A Legitimate, Effective Policy Tool

9 November 2020

By David Barwick – FRANKFURT (EconoStream) – European Central Bank Governing Council member Jens Weidmann said Thursday that sovereign bond purchases are a valid monetary policy instrument, while cautioning about the risk of fiscal dominance.

In a speech at an OMFIF Virtual Panel, a text of which was made available Monday by the Bundesbank, which he heads, he suggested that the second wave of the pandemic would hurt the economy this quarter, though not as much as the first wave had in the spring, and advocated a continued expansionary monetary policy stance.

Weidmann readily agreed that ‘government bond purchases can be a legitimate and effective monetary policy tool’, but warned that the purchases ‘involve the fundamental risk of mutualising sovereign liability risks through the central banks’ balance sheets.’

The combination of a lack of budgetary discipline and loose monetary policy ‘could be habit-forming.’, he said. If fiscal policy depends on the accommodation of monetary policy, ‘price stability might take a back seat’, he said.

The surge in public debt due to the pandemic could aggravate the problem if monetary policy comes under pressure to continue to accommodate fiscal policy, he said. Long-term price stability thus requires ‘a firm foundation that has to be laid by others’, a cornerstone of which is fiscal responsibility, he said.

‘We need to make it very clear that we are not going to place monetary policy at the service of fiscal policy’, he said. ‘If we create a different impression, we are putting both our independence and our credibility at risk.’

The resurgence of the pandemic ‘will place a strain on the economy in the current quarter’, he said. However, more targeted containment measures should lead to less of an economic impact than last spring, he said.

‘We have also learned that, when the protective measures were relaxed and people regained their confidence, the economy quickly revived’, he said. ‘The rebound in summer was, in fact, significantly stronger than expected.’

Still, he added, the pandemic may not be gotten under control that soon. ‘From today’s point of view, a succession of lockdowns and subsequent resurgences cannot be ruled out’, he said.

The disinflationary impact of economic developments make it important for monetary policy to stay expansionary, he said. Illiquid conditions could ‘dangerously aggravate the crisis’, and adverse feedback loops could also threaten price stability, he said.

That fiscal policy is leading the way is correct, he said, since unlike monetary policy it can compensate for income losses by redistributing money to affected households and firms. Fiscal policy needs ‘to ensure that a quick and strong recovery is possible again by stabilising the economy now, supporting a rebound and counteracting second-round effects’, he urged. A corporate insolvency wave must be avoided, he said.

For those member states with less fiscal room to manoeuvre, EU Recovery Fund support should be reciprocated with necessary reforms, he said. Part of this is a post-crisis return to budgetary discipline, he said. Although EU rules are meant to ensure this, to date ‘they have lacked teeth’, he said.

Turning to the strategy review of the ECB now underway, Weidmann said that a more symmetrically understood policy objective could lead to higher average expected inflation. ‘In my view, an explicitly symmetric formulation of our target would be clearer and easier to understand than our current wording, he said.

However, he continued, all aspects of the ECB’s objective – inflation rate, symmetry and time horizon – must be considered as a whole. Making the inflation objective a point could help anchor expectations, but could also potentially lead to policy inflexibility, he said. Flexibility matters, because monetary policy cannot achieve precise outcomes, he said.

Flexibility is also achieved by the current medium-term orientation of the objective, he said, which also allows for the time lag to which monetary policy is subject. ‘Monetary policymakers should be able to wait if there are good reasons to do so, and not react hastily to every change in the data’, he said.

Sometimes, though, monetary policy could use higher short-term expectations, he said, such as under conditions of low inflation when policy is near the effective lower bound. ‘Indeed, such situations might arise more frequently than in the past’, he said.

Average inflation targeting (AIT) ‘appears to offer a tailor-made solution for the current situation’, he said, but actually ‘raises some questions’. For example, after a lengthy period above target, the central bank would technically be obliged to reduce inflation ‘not only down to the target but even notably lower, into a range that the central bank currently regards as dangerous’, he argued.

While monetary policy makers could take an asymmetric approach to AIT, this would lead to time inconsistency issues and undermine the strategy’s credibility, he said. Moreover, expecting people to understand such a strategy and correspondingly form inflation expectations would be ‘asking a lot of market participants, but even more of households and firms’, he said.

Weidmann called it ‘undisputed that the HICP should really include’ owner-occupied housing, currently absent for technical reasons. ‘Personally, I would be willing to accept some methodological shortcomings in order to better reflect people’s real-life situations’, he said.

The medium-term orientation of the ECB’s current strategy is one of those elements ‘which have proven their worth’, he said. It facilitates the consideration of risks that don’t materialize quickly, he said.