ECB’s Schnabel: Would Need to Carefully Weigh Costs, Benefits of Another Rate Cut

26 February 2021

By David Barwick – FRANKFURT (Econostream) – Taking official borrowing costs further into negative territory would require careful consideration, European Central Bank Executive Board member Isabel Schnabel said Friday.

In a speech at a conference organised by the European Fiscal Board, the text of which the ECB made available, Schnabel said that the pandemic offered a prime example of how monetary policy’s traditional approach to mitigating demand-side shocks is rendered less effective by low real interest rates, given that the ECB did not reduce borrowing costs to counter the economic fallout.

‘Although there is some room left to reduce short-term rates further, the benefits and costs of deeper negative rates need to be weighed carefully’, she added.

The unconventional tools monetary policy has had to deploy to overcome the effective lower bound may be in danger of losing their effectiveness, she appeared to suggest.

On the one hand, she noted, the ‘very flat’ yield curve in the euro area implies ‘less scope for asset purchases to further compress term premia and thus long-term yields.’ On the other, she continued, demand can fail to respond to a further lowering of real rates in an environment of durably low rates.

‘The result could be a “macroeconomic reversal rate”, at which the costs of further easing, especially in terms of financial stability, could outgrow the benefits’, she said.

Under such conditions, monetary policy does best if flanked by other policies, she said. The response to the crisis caused by the pandemic, she said, ‘is a remarkable showcase for the power of monetary and fiscal policy interaction to boost confidence, stabilise aggregate demand and avoid a persistent destabilisation of medium to long-term inflation expectations.’

As for monetary policy itself, near the lower bound with financing conditions favourable, the focus should shift ‘away from instrument activism – that is, from the intensity with which it uses the available array of instruments – and towards the duration of policy support’, she said.

‘By credibly promising to preserve favourable financing conditions for as long as needed central banks underscore their unwavering commitment to the achievement of their mandate and ensure that monetary policy does not itself become a source of uncertainty, both with respect to its short-term reaction function and the potential vulnerabilities that too negative yield curve constellations could create in the future’, Schnabel elaborated.

The duration of policy support would rest on how well the public and private sectors take advantage of favourable financing conditions, she said, while the strength of policy support would depend on the evolving state of the economic recovery.

The central bank would thus need to watch closely how nominal rates move and consider carefully the underlying causes.

‘For example, a rise in nominal yields that reflects an increase in inflation expectations is a welcome sign that the policy measures are bearing fruit’, she said. ‘Even gradual increases in real yields may not necessarily be a cause of concern if they reflect improving growth prospects.’

‘However, a rise in real long-term rates at the early stages of the recovery, even if reflecting improved growth prospects, may withdraw vital policy support too early and too abruptly given the still fragile state of the economy’, she continued. ‘Policy will then have to step up its level of support.’

So that fiscal policy can help transmit monetary policy, the ECB has to ensure ample liquidity in the event self-fulfilling price spirals pose a threat, she said, potentially requiring ‘temporary flexibility in the use of instruments.’

Clearly establishing this ahead of time could pre-empt ‘destabilising dynamics’, she noted. Moral hazard objections ‘should not condemn the central bank to a course of inaction. These risks should be governed by other institutions outside crisis times.’