After Mario Draghi, French central bank Governor François Villeroy De Galhau joins the debate. He actually reverses the usual policy response to crisis/uncertainty. We are usually told monetary policy is the first response and then fiscal policy. He says given today’s times, fiscal policy comes first: Over the past decade, the world economy has steadily recovered from the global financial crisis. But it has not returned to its pre-crisis normal. Interest rates remain at historical lows, due to a historically low level of the natural rate of interest R*[i]. In the short run, this analysis – uncertainty as the first trigger of the present slowdown – should guide our ranking of policy answers. Monetary policy plays its role, but it should not – less than ever – be the only game in
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After Mario Draghi, French central bank Governor François Villeroy De Galhau joins the debate.
He actually reverses the usual policy response to crisis/uncertainty. We are usually told monetary policy is the first response and then fiscal policy. He says given today’s times, fiscal policy comes first:
Over the past decade, the world economy has steadily recovered from the global financial crisis. But it has not returned to its pre-crisis normal. Interest rates remain at historical lows, due to a historically low level of the natural rate of interest R*[i].
In the short run, this analysis – uncertainty as the first trigger of the present slowdown – should guide our ranking of policy answers. Monetary policy plays its role, but it should not – less than ever – be the only game in town. It should not even be the first game in town. The first response would be for government-driven uncertainties to be addressed directly by governments, by removing the self-induced threats to world growth.
Failing that, a second answer is for fiscal policy to step in. Fiscal stimulus from countries with fiscal space would both stimulate aggregate demand, and, with targeted, quality investment, increase long-term growth.[ii] Wage increases in countries that have long relied on wage moderation could also help in bolstering aggregate demand and inflation. And pro-growth reforms would raise R*.
Monetary policy provides a third response. For the past ten years, there is little doubt that ECB monetary policy under Mario Draghi’s Presidency has made a decisive contribution not only to safeguarding the euro in 2012, but also to the significant recovery of the euro area since 2013. Over this period, more than 10 million jobs have been created. Our unconventional measures are estimated to add almost 2 percentage points of growth and of inflation between 2016 and 2020. Since I am talking to an audience of researchers I should of course emphasise that such numbers are subject to uncertainty.
However, the most recent monetary policy decisions of the Governing Council have given rise to many comments. My rule of conduct has been to not add mine in the heat of the moment. Two weeks later, let me only say that I supported many elements of the package, including the strengthening of the state-dependent forward guidance and the welcome introduction of a tiering system, similar to those in all other jurisdictions with negative interest rates. But I was not in favour of the resumption of net asset purchases at this time, because I thought that further purchases are unnecessary right now, given the very low levels of both long-term interest rates and term premia, which have continued to decrease significantly since we stopped net purchases last December.
The main purpose of QE is to extract more duration risk from the bond market; indeed, term premia have already been successfully compressed – the term premium on a 10-year OIS is estimated to be significantly negative at around -60 to -100 bp. I also think that the significant strengthening of our forward guidance, the consequent prolongation of the reinvestment period for the very important stock of QE assets – 2600 billion euros –, and the DFR cut, were already a powerful and consistent combination. The forward guidance now states that we expect rates to remain at their present levels, or lower, until the inflation outlook robustly converges to a level sufficiently close to, but below, 2%, and this convergence has been consistently reflected in underlying inflation dynamics: our forward guidance is now strongly “state based”, reflecting our enhanced commitment to reach our objective. This is significant progress that has been overshadowed by the arguments over QE.
He also raises concerns with mon policy:
First, the measurement of key structural determinants remains surrounded with uncertainty. I mentioned the uncertainty surrounding the trend in R*. But similar uncertainty pertains to the measurement of potential output and the natural level of unemployment U*[iii]. We should also intensively work on the economic effects of climate change as a long-term but significant shock, and its interaction with monetary policy.
How to best measure inflation expectations is a second key issue. We know that expectations are key determinants of inflation, but it remains unclear what the most relevant measures of inflation expectations are. Expectations of professional forecasters (at 1,7 %) and market-based measures (at 1,3 %) have received most of the attention until now, but the expectations of firms as well as households – which can be significantly higher – matter at least as much for aggregate demand and price-setting. As Benoît Coeuré rightly stressed last July, more research is needed on what their expectations are, and how they form them.[iv]
Third, there is still much we do not know about how firms and households form expectations on future interest rates, and on how these expectations affect their spending decisions. We know that standard DSGE models tend to assume too much foresight from private agents. How to incorporate more realistic behavior is a central issue, especially when forecasting the effects of our new instruments such as forward guidance[v]. To be sure, some uncertainty over the response of the economy to our policies will always remain, especially when firms and households are themselves still learning how our new measures affect the economy, and how to live with very low or negative interest rates.[vi]
A last topic deserves, I believe, particular attention: the possible side-effects of our monetary tools on financial stability, especially the effects of unconventional monetary policies.
Times are changing?!