ECB Insight: Policy Sequencing Inversion Not Base Case But Still Not Excluded

26 November, 2021

By David Barwick – FRANKFURT (Econostream) – Although European Central Bank Executive Board member Isabel Schnabel in a speech earlier this month argued in favour of orthodox monetary policy sequencing as a way of limiting unwanted distributional side effects, Econostream continues to think, based on further conversations with insiders, that policy sequencing inversion is not excluded, depending on how the inflation outlook evolves.

As we reported a month ago, the idea of such inversion is not anathema to central bankers, even if the ECB, as demonstrated most recently by Schnabel, is officially resisting.

‘By gradually shifting the policy mix away from net asset purchases, we will prevent the distributional footprint of our measures from increasing and mitigate financial stability risks while the economy recovers’, Schnabel said.

The appropriate policy sequencing follows from this, she suggested, as hiking interest rates before ending net purchases would imply a loss on a central bank’s stock of assets ‘that would ultimately lead to losses for the average taxpayer, and the continuation of net asset purchases would benefit mostly wealthier households.’

Schnabel, referring to the distributional effects of ECB policies, called these a relevant factor in determining policy sequence ‘when the time has come’, meaning that while the ECB’s current forward guidance implies a certain policy sequence, it is not written in stone.

According to that guidance, net asset purchases under the asset purchase programme (APP) would ‘end shortly before [the Governing Council] starts raising the key ECB interest rates’, while reinvestment of principal payments from maturing securities purchased under the APP would continue ‘for an extended period of time past the date when it starts raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.’

Importantly, the ECB’s discussion of this sequence at the level of the Governing Council took place when central bankers were more or less uniformly convinced that the period of time required to reach their price stability target would be sufficiently lengthy to permit the standard, leisurely sequence of steps.

That conviction has increasingly come under assault. Although the prevailing view is still that inflation is going to follow a hump-shaped profile, a key question bearing on the issue of policy sequencing is: what level will inflation subside to? If it falls back to a level that still allows policymakers time to pursue price stability in more or less relaxed fashion – even if less time than previously envisioned - then orthodox policy sequencing remains the central scenario.

If inflation instead recedes to a still relatively elevated level, then that effectively narrows the window of time available to monetary authorities to take such a step-by-step approach, and as a side effect could thus call into question the standard sequence of policy support withdrawal.

Asked earlier this month about the subject, one ECB insider said he had ‘never seen anybody on the Governing Council defending this possibility in a serious manner.’ While not wishing to rule it out, this person said that for him, ‘tapering, hiking and then downsizing the balance sheet’ was ‘the central scenario.’

‘But I don’t mean that using the balance sheet as the marginal tool in the future couldn’t make sense’, he added. ‘It has some merits. But I don’t think the ECB is thinking of that at the moment.’

‘Moreover, for a jurisdiction like the euro area, playing with debt is always more difficult than for the UK or for the US’, he observed. ‘This leads me to think that if anything, the euro area is perhaps the least likely place to play with that.’

Another insider said the Governing Council would discuss the possibility of inverting the standard policy sequencing and in any case still had to clarify the forward guidance with respect to asset purchases, as this guidance – unlike that for interest rates – had not been updated following the conclusion of the ECB’s strategy review.

This person also noted the existence of arguments in favour of such inversion that were worth looking at, and said that the ECB’s new strategy did not imply a unique forward guidance, especially given the extent to which recent developments had altered the policy environment.

‘When facts change, views change’, he said. ‘We will not be casual and just come up with something different on a whim. But the current forward guidance may not be the only forward guidance that is consistent with the current strategy.’

Although the ECB would like to be able to tighten policy rather than risk finding itself near the effective lower bound when the next crisis hits, which is ‘only a matter of time’, that ‘does not mean that we are in a hurry to raise rates’, he said. ‘We will be patient, as we have said.’

However, ‘if we are very cautious at the beginning, we may need to raise rates somewhat faster down the road’, he continued. ‘So, the forward guidance needs to be completed in terms of asset purchases, but if the situation changes, we may improve on our forward guidance if necessary.’

Neither he nor a third insider thought that the risks of persistently high inflation had augmented to such a degree that the ECB would be forced at its December policy meeting to prepare specifically for such an eventuality.

Based on her speech earlier this month, neither would Schnabel. Still, earlier this week, she called inflation risks ‘skewed to the upside’ and arguing that ‘[u]ncertainty has increased with respect to the pace and extent of the decline.’

It’s precisely concerns about the pace and extent of the inflation decline once past the hump that, at least for other policymakers, could be a reason to put policy sequencing inversion on the ECB’s agenda yet.