In an economic context of crisis, the traditional tools of monetary policy may prove to be ineffective. While the central bank has already significantly reduced its key rates by placing them at levels very close to 0% (we then speak of the lower bound of zero), it may be faced with two difficulties:
- inflation remains persistently below the central bank’s target, and inflation expectations, economic agents’ forecast of price dynamics in future years, are also below target. In the worst case, deflation can threaten the economy, leading to a deflationary spiral from which it is very difficult to escape;
- financial institutions do not pass on the reduction in key rates to the real economy via the issuance of credit, thus preventing the stimulation of demand from economic agents which would generate inflation.
In these two situations, the central bank must have recourse to other instruments to conduct its monetary policy. We will identify four non-standard instruments.
By increasing the size of its balance sheet (quantitative easing or quantitative easing), the central bank massively buys assets on the financial markets including mainly bonds issued by States. It thus directly or indirectly promotes the revival of demand by supporting fiscal policy and it allows interest rates to fall. Since the launch of its first program launched in October 2014 following the sovereign debt crisis, the ECB has purchased nearly 3,260 billion euros in assets. We must add to this 1,700 billion euros purchases in response to the Covid-19 crisis.
However, this tool questions the independence of the central bank which finances fiscal policy (and budget). However, in a context of low inflation below the central bank’s target, the central bank remains consistent with its mandate. So it is normal, in a crisis situation, to have an alignment between fiscal policy and monetary policy. Moreover, the fact of holding the bonds of the Member States does not modify the political independence of the ECB.
But maintaining this monetary policy for an extended period of time can generate difficulties. Firstly, it makes the central bank sensitive to financial market fluctuations – making it in fact bear the risks, such as default (“bankruptcy”) – associated with bond holding. In a second time, this policy can increase risk taking by the banking sector which sees its margins reduced by the low yield on bonds and loans. Finally, it can promote the emergence of bubbles in certain financial or real assets.
The central bank can also with qualitative easing (qualitative easing), change the quality of the collateral it accepts during its operations. Financial institutions holding risky assets, that is to say whose probability of default is high, as was the case with Greek government bonds during the sovereign debt crisis, find themselves unable to issue new loans. By exchanging these assets for liquidity, these institutions can once once more issue credit to economic agents.
another tool available to the central bank is the establishment of negative interest rates during its refinancing operations, as was the case in Denmark from July 2012. The banks are thus remunerated when they borrow, encouraging the issuance of credit. Negative rates can also be applied to standing deposit facilities as the ECB did from June 2014 to July 2022: depositing cash with the central bank thus becomes costly for financial institutions, which are therefore strongly encouraged to finance the real economy.
The last instrument available to the central bank to fight inflation relies on its communication. By providing economic agents with information on its future monetary policy, the central bank is better able to bring down medium- and long-term interest rates. It therefore becomes more effective in the conduct of its monetary policy. Since July 2013, the ECB has therefore used the forward guidance of interest rates (forward guidance) during his press conferences.
While the European Central Bank is now fighting once morest too high inflation, this communication still sends a clear signal to economic agents, suggesting that the ECB should continue to use it regardless of the economic context. But while the existing tools to fight once morest too low inflation are numerous, the instruments for reducing excessive inflation are much more limited, showing the limits of monetary policy.
