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More patience needed: ECB adjusts to weaker growth outlook
ECB further eases monetary policy stance by delaying the date of the first rate hike and launching a new round of targeted longer-term bank refinancing
Further easing is accompanied by substantial downward revisions of ECB macroeconomic projections both for GDP growth and inflation
The European Central Bank (ECB) has aligned its monetary policy stance to a weaker economic and inflation outlook. Last week’s meeting has brought two adjustments to further ease monetary conditions. Firstly, key ECB interest rates are now expected to “remain at their present levels at least through the end of 2019” and not only “the summer of 2019” as having been previously stated. Secondly, the ECB Governing Council has decided to initiate a new round of targeted longer-term refinancing operations (TLTRO), starting in September 2019. TLTROs, which enable banks to borrow from the ECB at maturities of two years, are conditional on the stock of eligible loans and intend to preserve favorable bank lending conditions and a smooth transmission of monetary policy. These adjustments to the monetary policy stance were accompanied by a severe downward revision of ECB staff macroeconomic projections. Real growth of Euro Area gross domestic product (GDP) has been lowered to 1.1 % for the year 2019, down from 1.7 %. Inflation is now expected to average 1.2 % in 2019, down from 1.6 %. Risks to the outlook remain titled to the downside, particularly as external factors weigh on economic growth, which lie outside the ECB’s reach.
The primary objective of the ECB’s monetary policy is to maintain price stability, which it defines as inflation of below, but close to, 2 % over the medium term. Last week’s monetary policy decision was taken to ensure that inflation remains on a sustained path towards fulfilling the ECB’s aim. Weaker economic growth slows down the pass-through from nominal wage growth to higher prices, why an additional stimulus was decided to be necessary. Looking at previous ECB staff macroeconomic projections of underlying inflationary dynamics, here we refer to the core inflation measure HICP excluding energy and food, shows that core inflation has reached 1.8 % at the end of the projection horizon since the March 2018 projections. In the March 2019 projections, however, core inflation is projected at 1.6 % in 2021, compared to 1.8 % in December 2018. Hence, it is not only the year 2019 for which projections were altered. The whole path of inflation as converging to the inflation target has been shifted.
As the inflation outlook remains subdued for longer than previously expected, a delay of the first interest rate increase is consistent with the ECB’s price stability objective. The ECB expects key ECB interest rates to remain at their present levels at least through the end of 2019. Several members of the Governing Council even suggested to change the date to March 2020. Market expectations, as measured by Overnight Index Swap (OIS) Forward Rates, indicate no rate hike until March 2020. The 1-month EONIA (Euro Overnight Index Average) rate is expected to be approximately 20 basis points (bp) higher in 2 years (March 2021) and 40 bp higher in 3 years. Figure 1 (see pdf) shows that market expectations of the ECB’s interest rate path have decreased considerably since October 2018.
With respect to TLTROs the specific terms are not yet available. What is known so far is that TLTROs will start in September 2019, end in March 2021, have a maturity of 2 years, the rate is indexed to the interest rate on the main refinancing operations and the amount to be borrowed is limited to 30 % of the stock of eligible loans.
Overall, all measures, which were taken last week, should not have come as a surprise. A change in the forward guidance with respect to the date of a first rate hike has been heralded by forward rates. That TLTROs are subject to discussions at the ECB has been known for some time. And that past staff projections will need a substantial downward revision was clear, at least, since a growth rebound in Q4 2018 has not materialize.
Evaluating ECB Taylor rules
We implement several different monetary policy rules in an aim to show which specifications work for the European Central Bank
This includes estimates discussed by the German Council of Economic Experts, ex-Fed Chair Janet Yellen and the ECB itself
Finally, we propose our own specification.
Taylor rules are a simple and easy to implement though insightful guide to monetary policy, which is widely used both in theoretical macro modelling as well as practical applications. The canonical representation of the Taylor rule is written as
r_t=r^*+π_t+0.5(π_t-π^* )+0.5y_t
where r_t is the key interest rate, r^* is the equilibrium real rate of interest, π_t is the inflation rate, π^* is the central bank’s inflation target and y_t is the output gap in period t. The key interest rate rises if inflation increases above the inflation target (2 %) or if real gross domestic product (GDP) rises above potential GDP. If both the inflation rate and real GDP were on target, then the key interest rate would equal 4 % in the United States when J. Taylor published his seminal paper. The equilibrium real interest rate was set as constant at 2 % and close to the assumed steady-state growth rate of U. S. gross domestic product (GDP) of 2.2 % (1984-1992). The policy rule fit the actual path of the federal funds rate quite well (1987-1992). The Taylor rule would tell us to expect that over the medium term the nominal short-term (risk-free) interest rates would hoover around 4 % in the United States.
In the Euro Area (EA), the average GDP growth rate equaled 1.3 % since 2002 and the European Central Bank (ECB) targets inflation below but close to 2 % (~1.7 % on average since 2002), hence, a neutral main refinancing rate could be thought of as around 3 % in the past, according to the canonical Taylor rule. For the EA, estimates for a steady-state or potential growth rate are more difficult. Average potential growth from European Commission’s Ameco database and the OECD economic outlook would be 1.3 % since 2002. A time-series smoothed by using a standard filter method (Hodrick-Prescott filter, HP) would imply 1.4 % potential GDP growth since 2002. Adding the medium-term ECB inflation target, the nominal short-term (risk-free) rate of interest would be 3.0-3.1 % for the EA. Based on different estimates for potential growth, Taylor rules were estimated for selected EA countries. We replicate rules for the total EA using combinations of different inflation measures (headline and core inflation, GDP deflator, inflation expectations form the ECB Survey of Professional Forecasters), estimates for trend/potential growth (Ameco, IMF and a HP-filtered time series) and corresponding estimates for output gaps (Figure 1 - see pdf).
These Taylor rules do not fit very well the path of the ECB main refinancing rate since 2002. The indicated interest rate level is too high for the period from 2002 until 2008, it does not account for the need for quantitative easing after 2008, which would be signaled by a negative policy rate and it indicates increases in the policy rate to around 3 % since 2017.
The next set of Taylor rules incorporates estimates of the equilibrium real rate of interest, which takes a different trajectory than potential growth. Methods of estimation for r* take better account of what has been called the “new normal” of low interest rates and the most prominent approaches were by Laubach and Williams (LW) and Holston, Laubach and Williams (HLW). R-star is the neutral or natural rate of interest and it is the real interest rate that we expect to prevail in the long run when interest are neither providing a boost to the economy nor trying to cool things down (neither accommodative and nor contractionary). As can be seen in Figure 2 (see pdf), the Taylor rule incorporating r* performs similarly badly for the period 2002 to 2008 – indicating a level too high compared to the main refinancing rate. However, it seems to capture better the decline of interest rates since the global financial crisis (GFC) in 2008/09 and negative interest rates after the Euro crisis in 2011/11. Still, these rules indicate increasing rates since 2017 to almost 2 %, although these levels are lower than the ones indicated by Taylor rules based on potential growth rates (Figure 1 - see pdf).
A third set of Taylor rules that we juxtapose is based on rules which were proposed by former Fed Chair J. Yellen for the U. S. economy. These rules include the balanced rule, the change rule and a Taylor rule based on the unemployment gap instead of the output gap (Figure 3 - see pdf). The unemployment gap (UR gap) is usually calculated as two times the actual unemployment rate minus the non-accelerating inflation rate of unemployment (NAIRU, a measure for the structural unemployment rate). The balanced rule puts a larger weight on the output gap (1.0 instead of 0.5), while the change rule includes the lagged value of the main interest rate instead of the equilibrium rate and puts a larger weight on the inflation gap.
The monetary policy rules, which Yellen mentioned, seem to capture the period after the GFC quite well and account for the phase, when the key interest rate hit the zero lower bond (ZLB). After the main refinancing rate was lowered to zero, the European Central Bank had to revert to unconventional monetary policy (including quantitative easing, ‘QE’) in order to decrease interest rates in the Euro Area further. These policy rules indicate such a negative interest rate trajectory.
Alternatively, authors from the ECB itself recommended a first-difference policy rule in a recent publication. The Orphanides rule links changes in the main refinancing rate to deviations of the one-year ahead inflation forecast from the inflation target and deviations of the one-year ahead forecast for real GDP growth from potential growth (Figure 4).
Note that this policy rule is a bit more difficult to interpret as it indicates quarterly changes in the main policy rate whereas traditional Taylor rules describe the path of the level of the policy rate. The advantage of the Orphanides rule is that it does not rely on unobservable concepts like the output gap. It only relies on the potential growth rate estimate and it responds “to perceived imbalances between the growth rate of aggregate demand and aggregate supply and not an output gap”. Still, according to this rule, the ECB would have opted for increasing the main policy rate since mid of 2017.
The analysis of different policy rules, which are suggested in the relevant literature, leaves us unsatisfied so far. No rule works quite well in replicating the recent actual path of the ECB policy rate. How can we improve?
First, we can vary the weights for the inflation and the output gap. Frequently, the literature about Taylor rules suggest raising the weight of the inflation gap to 1.5 (instead of 0.5) while leaving the output gap weight unchanged compared to the classic Taylor rule. This would emphasize the strong responsiveness of the ECB to inflation under- or overshoots versus the target while placing a lower weight on the output gap. It is also more consistent with the ECB’s sole aim for price stability, whereas the U.S. central bank has a dual mandate for price stability and maximum employment. It implies a more than proportional response to changes in the inflation gap. Second, we use an estimate of the HLW real equilibrium rate of interest (r*). We have learned above (Figure 2 - see pdf) that the decline in interest rates since the GFC is reflected better than by using trend/potential growth rates. Measures of output gaps have been criticized as notoriously unreliable. Hence, third, we replace the output gap with the unemployment gap, as suggested in Yellen’s speech. Finally, the core HICP inflation rate (excluding volatile energy and food prices) is used as a measure for price changes.
This specification (Figure 5 - see pdf) fits better the trajectory of the ECB’s main refinancing rate than rules discussed above (Figures 1 to 4 - see pdf). Like these rules it indicates a higher interest rate for the period before the GFC. However, for the period since 2008, it captures very well the secular decline in the equilibrium rate of interest (r*). Moreover, the rule takes account of the large rise in unemployment rates since the onset of the Euro crisis (2010/11), while at the same time incorporating the strong central bank response to the drop in inflation in the ECB’s aim to reach its inflation target. The suggested Taylor interest rate approaches zero from below what also seems to capture the ECB’s forward guidance which indicated a monetary policy normalization until recently.
In this issue, we discuss different specifications of Taylor rules for the Euro Area, which have been proposed in the relevant literature, and we add our own proposal. We do not know any central bank which mechanically just follows such a rule, nevertheless they are a simple though insightful guide to understand monetary policy and they are widely used in both monetary theory as well as practical evaluation. We show that empirical estimates of the real equilibrium rate of interest capture better the “new normal” of low rates compared to the traditional use of trend or potential growth rates. Output gaps bear high uncertainty and looking at divergence of unemployment rates from its structural levels might be preferable. A more than proportional response to deviations of the inflation rate form the target likely reflects the ECB’s sole mandate for price stability.
Authors
Martin Ertl Franz Xaver Zobl
Chief Economist Economist
UNIQA Capital Markets GmbH UNIQA Capital Markets GmbH
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