STUDY

Requested

Monetary

bytheECONcommittee

DialoguePapers,February

2024

EuropeanParliament

TheEuroat25:Fitfor

purpose?

#EUROat25

Authors:

-LuaeziaRECHLIN

-JeanPISANIFERRY

-JerominZETTELMEYER

ks

EconomicGovernanceandEMUScrutinyUnit(EGOV)

Directorate-GeneralforInternalPolicies

EN

PE747.834-February2024

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TheEuroat25:Fit

forpurpose?

Abstract

ThispaperreviewstherecordofEuropeanCentralBankpolicymakingsincethe2010-12eurocrisisinordertodeveloprecommendationson:(1)theECB’sfuturemonetarypolicystrategy,(2)itsoperationalframework,and(3)thegovernanceofEuropeanEconomicandMonetaryUnion.

ThisdocumentwasprovidedbytheEconomicGovernanceandEMUScrutinyUnitattherequestoftheCommitteeonEconomicandMonetaryAffairs(ECON)aheadoftheMonetaryDialoguewiththeECBPresidenton15February2024.

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ThisdocumentwasrequestedbytheEuropeanParliament'sCommitteeonEconomicandMonetaryAffairs.

AUTHORS

LucreziaREICHLIN,LondonBusinessSchool,Bruegel,andCEPR.

JeanPISANI-FERRY,Sciences-Po,BruegelandPIIE.

JerominZETTELMEYER,BruegelandCEPR.

ADMINISTRATORRESPONSIBLE

GiacomoLOI

DrazenRAKIC

MajaSABOL

EDITORIALASSISTANT

AdrianaHECSER

LINGUISTICVERSIONS

Original:EN

ABOUTTHEEDITOR

TheEconomicGovernanceandEMUScrutinyUnitprovidesin-houseandexternalexpertisetosupportEPcommitteesandotherparliamentarybodiesinshapinglegislationandexercisingdemocraticscrutinyoverEUinternalpolicies.

TocontactEconomicGovernanceandEMUScrutinyUnitortosubscribetoitsnewsletterpleasewriteto:

EconomicGovernanceandEMUScrutinyUnit

EuropeanParliament

B-1047Brussels

E-mail:egov@ep.europa.eu

ManuscriptcompletedinJanuary2024

?EuropeanUnion,2024

Thisdocumentwaspreparedaspartofaserieson“Euro@25:What'snextfortheEMU?”,availableontheinternetat:

https://www.europarl.europa.eu/committees/en/econ/econ-policies/monetary-dialogue

DISCLAIMERANDCOPYRIGHT

TheopinionsexpressedinthisdocumentarethesoleresponsibilityoftheauthorsanddonotnecessarilyrepresenttheofficialpositionoftheEuropeanParliament.

Reproductionandtranslationfornon-commercialpurposesareauthorised,providedthesourceisacknowledgedandtheEuropeanParliamentisgivenpriornoticeandsentacopy.

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CONTENTS

LISTOFABBREVIATIONS6LISTOFFIGURES7LISTOFTABLES7EXECUTIVESUMMARY81.INTRODUCTION9

2.THERECORD11

2.1.Thebattleagainstlowinflation,2013-202011

2.2.The2020COVID-19response17

2.3.TheexitfromCOVID-19andthereturnofinflation,2021-2218

2.4.Tighteninganddisinflation,2022-2320

3.ECBSTRATEGYANDOPERATIONALFRAMEWORK23

3.1.Strategy23

3.1.1.Thepricestabilityobjective23

3.1.2.Monetarypolicyinstruments24

3.2.TheoperationalframeworkandthesizeoftheECBbalancesheet25

4.IMPROVINGTHEFISCAL-STRUCTURALUNDERPINNINGSOFEMU29

4.1.Improvingmonetary-fiscalcoordinationandexpandingEU-levelsafeassets29

4.2.Reducingfiscal-fragmentationriskswhenmonetarypolicyneedstotighten31

4.2.1.SimplifyingtheTPI33

4.2.2.Reducingdirectexposureofbankstotheirownsovereignsinnormaltimes34

5.CONCLUSION36

REFERENCES38

ANNEX41

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LISTOFABBREVIATIONS

ABPP

APP

Asset-backedsecuritiespurchaseprogramme

Assetpurchaseprogramme

CBPP

CSPP

DFR

ECB

Coveredbondpurchaseprogramme

Corporatesectorpurchaseprogramme

DepositFacilityrate

EuropeanCentralBank

EMU

EP

ESM

EconomicandMonetaryUnion

EuropeanParliament

EuropeanStabilityMechanism

EU

EuropeanUnion

GDP

Grossdomesticproduct

HICP

Harmonisedindexofconsumerprices

LTROs

MRO

NCBs

OIS

PEPP

PSPP

QE

QT

Longer-termrefinancingoperations

Mainrefinancingoperations

NationalCentralBanks

Overnightindexedswap

Pandemicemergencypurchaseprogramme

Publicsectorpurchaseprogramme

Quantitativeeasing

Quantitativetightening

SMP

SecuritiesMarketProgramme

TLTRO

Targetedlonger-termrefinancingoperations

TPI

Transmissionprotectioninstrument

USD

USdollar

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LISTOFFIGURES

Figure1:EuroareaandUSeconomicperformance,pre-,during,andpost-COVID-1911

Figure2:EurosystemassetsandkeyECBinterestrates12

Figure3:IndexofEurosystemandFederalReserveassetsasapercentageofeuroareaandUSGDP

(Q1of2000=100)14

Figure4:1-yearovernightindexswap(OIS)rateshocksaroundECBpressconferences(inbasis

points)15

Figure5:InflationexpectationsintheEuroareaandtheUS15

Figure6:Selectedsovereignspreadswiththebundon10-yearbenchmarks(inbasispoints)andkey

policydates18

Figure7:Coreinflationratesintheeuroarea(panelA)andtheUS(panelB)20

Figure8:ECBHICPforecastsvs.actualHICP21

Figure9:Creditconditionsintheeuroarea22

Figure10:ExcessreservesheldintheECB’sdepositfacility26

Figure11:Domesticgovernmentbondsasashareofmonetaryfinancialinstitutions(MFI)totalassets

32

Figure12:MeasuresofItaliansovereignandbankspreads(inbasispoints)33

LISTOFTABLES

Table1:KeyECBpolicydecisions41

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EXECUTIVESUMMARY

?ThispaperreviewstherecordofEuropeanCentralBank(ECB)policymakingsincethe2010-12eurocrisisinordertodeveloprecommendationson:(1)theECB’sfuturestrategy,(2)itsoperationalframework,and(3)thegovernanceofEconomicandMonetaryUnion(EMU).Thepurposeisnottoundertakeacomprehensiveevaluationof25yearsofEMU.Rather,itistoestablishwhetherreformsandpolicychangessincethecrisisaresufficienttoremedythedefectsofthecurrencyunionfromtheperspectiveoftheconductofmonetarypolicywhichwereexposedbythecrisis.

?Since2012,theECBhasprovenadaptiveandinnovativeinitspolicyframeworkandinstruments.Ithasalsobeenfastandeffectiveinaddressingfinancial-stabilityriskstotheeuro.Withrespecttomonetarypolicy,however,ithasbeenlateontwoimportantoccasions:initsJanuary2015decisiontoundertakelarge-scaleassetpurchasesincludingsovereignbonds,andinitsJuly2022decisiontoraiseinterestrates.

?Wearguethatthesedelayshadacommoncause:thepoliticalandfiscalfragmentationoftheeuroarea.ThiscreatedastructuralhandicapfortheECB,reflectedinconcernsaboutthedistributionalimpactofassetpurchasesontheonehand,andthefinancialstabilityimpactofmonetarytighteningontheother.

?The2021ECBstrategyreviewmarkedsignificantprogressbutleftmajorissuesunaddressed.Theseinclude:(1)aprocessforreviewingand(ifnecessary)adjustingthequantitativedefinitionoftheECB’spricestabilityobjective,(2)thedefinitionofthe‘mediumterm’horizonoverwhichpricestabilityshouldbeachieved,and(3)therelationshipbetweenthathorizonandECBsecondarytargets,suchasfinancialstability.Theseissuesshouldbetakenupinthenext(2025)strategyreview.WithrespecttotheECB’smuch-expandedmonetarypolicyinstrumenttoolbox,thereisaneedtoclarifyandexplainhowtheseinstrumentswilloperatetogetherinthefuture.

?The‘amplereserves’operationalframeworkthatencouragesbankstoholdlargebuffersofexcessivereserveshasworkedwellinreconcilingmonetarypolicycontrolwithfinancialstability;itshouldberetained.WearguethattheECBshouldretainbothrefinancingoperationsonafull-allotment,fixed-ratebasis,andastructuralbondportfoliothatenablesittocontrolbankliquiditythroughbondpurchasesandsalesifneeded.

?Overcomingthestructuralhandicapoftheeurorelativetosingle-countryreservecurrenciesdoesnotrequirefullfiscalunion,butitrequiresbothaliquidandsafebondmarketandsomemechanismtoensurethatthecombinedstabilisationeffortbyfiscalandmonetaryauthoritiesissufficient.Theseaimsccouldbeinprincipleachievedthroughthecombinationof:(1)alargerEUbudgetsupportedbycommonborrowing,(2)furtherimprovementstoECBpolicyinstrumentstoreducethefinancial-stabilityriskslinkedtofiscalfragmentation,and(3)reducingvulnerabilitiesthatleadtofiscalfragmentation,byrebuildingfiscalbuffersandbyreducingthesovereignexposuresofbankswhilenotprecludingthepossibilityofraisingexposuresagainincrisistimes.Withoutaconsensusamongstmemberstatesontheimplementationofthesepolicies,thestructuralhandicapislikelytopersist.

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1.INTRODUCTION*

TheEconomicandMonetaryUnion(EMU)hassurvivedtwolargeeconomiccrises.IthasalsoexperiencedaprotractedperiodinwhichinflationundershottheEuropeanCentralBank’s(ECB)pricestabilitytarget,andabriefbutunusuallyadverseperiodofhighinflation.Toadapttothechallenges,theUnionhasrespondedbyreformingitspolicyconceptsandinstitutions.ThesehaveincludedsignificantchangesintheECB’spolicyframework,strategyandinstruments.TheECBisnowaverydifferentinstitutiontothatwhichwasoriginallydesigned.

Manyofthesechanges,however,havebeenintroducedbynecessityandoftenaftercostlydelaysandhesitation.WhiletheECB’sabilitytoadaptisasignofresilience,itisimportanttounderstandwhetherthesedelaysmerelyresultfrombehaviouralbiasesorreflectastructuralproblem.Thisiswhatweattemptinthispaper.Moreover,newrisksareloomingthatmaycallforchangesintheECB’sstrategy,andmoregenerallyforreformoftheEMU.

ThepurposeofthispaperisalsotopresentideasforthenextstepsofEMU,focusingontheECBandtheelementsofEMUgovernancethataremostdirectlyrelevanttotheECB’smandate.ThebasisforouranalysisisthehistoricalrecordofECBpolicysince2012,thatis,afterthereformsoftheeuroareainstitutionalandpolicyframeworksthatweretriggeredbytheeuroareacrisisof2010-12.Hence,thepurposeisnottoundertakeacomprehensiveevaluationof25yearsofEMU1.Rather,thequestioniswhetherthereformsandpolicychangesintroducedsincethecrisisaresufficienttoremedythedefectsofthecurrencyunionrevealedbythecrisis,fromtheperspectiveoftheconductofmonetarypolicy.

Theremainderofthepaperisdividedintothreesections.Section2describesandreflectsonthelastdecadeofECBpolicy,startingwiththestabilisationoffinancialmarketsaftertheeurocrisis,andendingwiththerecentexperiencewithhighinflationanddisinflation.Section3discussesthelessonsthattheECBitselfhasdrawninitsstrategyreviewof2021,inrelationtochallengesthatemergedaftertheCOVID-19pandemic.Section3alsoidentifiesopenquestionsthatshouldbeaddressedinthenextstrategyreview,tobepublishedin2025.IttakesaviewonwhethertheECBshouldformallyadopttheoperationalframeworkof‘amplereserves’,whichhasbeeninusesince2008.InSection4,wediscusswhatouranalysisimpliesforthefiscal-structuralenvironmentinwhichtheECBoperates,waysinwhichfiscalpolicyinEMUcouldbecomemorecentralised,andreformsthatcouldreducethefragmentationofEMUarisingfromdifferencesinfiscalfundamentals.

WefindthattheECBhasgenerallybeensuccessfulinadaptingtoadifferenteconomicandfinancialenvironmentthantheoneitsdesignershadinmindwhenpreparingformonetaryunion.ButwealsofindevidencethatthejoboftheECBhascontinuedtobeharderthanthatofothercentralbanks,forreasonsthatrelatetothepoliticalandfiscalenvironmentinwhichitoperates.Aftermonetarypolicybecameconstrainedbytheeffectivelowerboundoninterestrates,distributionalconcernsresultingfromthisfragmentationdelayedthedeploymentofECBassetpurchasesasamonetarypolicyinstrument,eventhoughsuchpurchaseprogrammeshadlongbeenpartofthetoolkitofothermajorcentralbanks.Andasinflationconcernscametotheforein2021-2022,fiscalfragmentationworries

*

1

ReichlinisaffiliatedwithLondonBusinessSchool,BruegelandCEPR;Pisani-FerrywithSciences-Po,BruegelandCEPR,andZettelmeyerwithBruegelandCEPR.Contacte-mails:Lreichlin@;jean.pisani-ferry@;jeromin.zettelmeyer@.WearegratefultoConorMcCaffreyforoutstandingresearchassistanceandtoAndreasBillmeier,MarcoButi,RebeccaChristie,ZsoltDarvas,MariaDemertzis,KrishnaGuha,GiacomoLoi,FrancescoPapadia,FrancescoNicoli,LucioPench,DrazenRakic,MajaSabol,NicolasVéronandparticipantsoftheESM-CEPRJointConference:‘RebuildinganAgendaforEurope’,1February2024,forhelpfulcommentsandsuggestions.Theauthorsaresolelyresponsibleforanyremainingerrors.

Hence,thepaperdoesnotcoverthepre-crisisandcrisishistoryofEMU,nordoesitevaluateEMUgovernancemorebroadly.Forarecentstock-takecoveringtheentire25yearsofEMU,seeCorsettiandButi(2024).Foradiscussionoftheeuro-areacrisisandwhatitrevealedabouttheflawsoftheeuroarchitecture,seePisani-Ferry(2014).Forarecentdiscussionoftheunfinishedagendaonbankingunion,seeBecketal.(2022).FortheunfinishedagendaonCapitalMarketsUnion,seeHighLevelForumonCapitalMarketsUnion(2020).Foradiscussionofthemostrecentattempttoreformthefiscalrules,seeBlanchardandZettelmeyer(2023),Darvasetal(2023)andZettelmeyer(2023a,b).

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delayedtheECB’stighteningofmonetarypolicy,withtheconsequencethatitseventualreactionhadtobemoreforceful.DistributionalconcernsrelatedtofiscalfragmentationarealsoamajorcomplicatingfactorintheongoingdiscussionofwhetherandhowtochangetheECB’soperationalframeworkwithinthecontextofthecurrentreview.

Ourmainconclusionishencethattheclaimthat“successfulmonetaryunionrequiresfiscalunion”isindeedatleastpartlyright.Successfulmonetaryuniondoesnotrequirefullfiscalunioninthesenseofafederalstate.Butitrequiresbothaliquidandsafebondmarketandsomemechanismtoensurethatthecombinedstabilisationeffortbyfiscalandmonetaryauthoritiesisappropriate.Intheabsenceoffullfiscalunion,theseaimscanbeachievedthroughthecombinationof:(1)alargerEUbudgetsupportedbycommonborrowing;(2)furtherimprovementstoECBpolicyinstrumentstoreducethefinancialstabilityriskslinkedtofiscalfragmentation,and(3)stepstoreducevulnerabilitiesleadingtofiscalfragmentation,byrebuildingfiscalbuffersincountrieswithdebtsustainabilityrisks,andloweringthesovereignexposuresofbanks.

Thesearedifficultstepsintheirownright,particularlythefirst,whichrequiresunanimityofallmemberstates.TheECB’sstructuralhandicapwillhencenotbefullyovercomeuntilthereismuchgreaterconsensusintakingstepstowardfiscalunionthanispresentlythecase.

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2.THERECORD

2.1.Thebattleagainstlowinflation,2013-2020

Inthesecondhalfof2012,theacutephaseofthesovereigndebtcrisiscametoanend,reflectingthecombinedeffectoftheestablishmentoftheEuropeanStabilityMechanism(ESM),thepoliticalagreementonBankingUnion,andECBPresidentMarioDraghi'sfamousannouncementthat"within

ourmandate,theECBisreadytodowhateverittakestosavetheeuro".Thiswassoonfollowedbythe

announcementoftheoutrightmonetarytransactionsprogramme(OMT,meaningunlimitedbondpurchases),asalastresorttostabilisesovereigndebtmarketsincountrieswithESMprogrammes(seeTable1,Annex,forachronologyofECBpolicyactions).

Figure1:EuroareaandUSeconomicperformance,pre-,during,andpost-COVID-19PanelA:Euroareaeconomicperformancepre-,during,andpost-COVID-19

2020-05

2021-062022-012022-072023-022023-08

Source:BruegelbasedonECBandOECD;ECBSurveyofProfessionalForecasters.

PanelB:USeconomicperformance,pre-,during,andpost-COVID-19

2020-12

Source:BruegelbasedonFederalReserveandOECD.

Sovereignspreadsdeclinedrapidly,andtheeuroareaexitedtheseconddipofaprolongedrecessionthathadbeentriggeredinitiallybythefinancialcrisisinthefirstquarterof2013.However,therecoveryremainedweak,with2013-14growthaveragingjust0.6%(comparedto2%intheUnitedStates),and

ECBPresidentMarioDraghi'sspeechattheUKTradeandInvestmentGlobalInvestmentConference,26July2012.See

/watch?v=tB2CM2nqpQq

.

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awideningoutputgaprelativeto2012(whileitdeclinedcontinuouslyandmarkedlyintheUS).Inflationwasalsowellbelowthetarget(definedas"justbelow2%"atthetime):HICPannualinflationaveragedonly0.34%during2013-14andonly0.96%during2013-19,comparedto1.54%and1.55%,respectively,fortheUS(Figure1).

Figure2:EurosystemassetsandkeyECBinterestrates

PanelA:Eurosystemassets(left)andkeyECBinterestrates(right)

-EurosystemAssetsMarginalLendingFacilityrateDepositFacilityrate.MainRefinancingOperationsrateEuriborrate(3m)

Source:BruegelbasedonECBandBloomberg.

Note:Keypolicydatesaddedbyauthors.GreyareasindicateeuroarearecessionsaccordingtotheCEPREuroAreaBusinessCycleDatingCommittee.

PanelB:Eurosystemassetsbyclass(EURtrillion)

Source:BruegelbasedonECBandBloomberg.

Note:MRO=mainrefinancingoperations,LTRO=longer-termrefinancingoperations,SMP=SecuritiesMarket

Programme,ABSPP=asset-backedsecuritiespurchaseprogramme,CBPP=coveredbondpurchaseprogramme,PSPP=publicsectorpurchasingprogramme,CSPP=corporatesectorpurchaseprogramme,PEPP=pandemicemergencypurchaseprogramme.OtherAssetsincludesgoldandgoldreceivables,claimsonnon-euroarearesidentsdenominatedinforeigncurrencyandeuro,claimsoneuroarearesidents

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denominatedinforeigncurrency,otherclaimsoneuroarearesidents,generalgovernmentdebtandothersecuritiesofeuroarearesidents.

Theweaknessoftherecoverywasaconsequenceofbothafragilefinancialsystemandinsufficientpolicystimulus.Bylate2012,marketinterestrateshadfallentothebottomofthecorridorsetbytheECB,thecentralbank'sdepositfacilityrate(DFR),whichhadbeenatzerosinceJuly2012.Thisreflected

large-scaleliquidityprovidedbytheECBtobanksintheformofthree-yearlong-termrefinancingoperations(LTROs)conductedbylate2011andearly2012,whichbankshadredepositedintheECB’sdepositfacilityasexcessreserves.Fiscalpolicywasstilltightandwouldremainsountil2014.Andbankeffortstodeleverageandrepayfundingborrowedunderthethree-yearlongLTROsoflate2011andearly2012graduallyledtoa‘passivetightening’offinancialconditions(seeFigure2,showingthedeclineinthesizeoftheeuro-systembalancesheetfrom2012to2014,andthesimultaneousgradualriseoftheEuriborinterestrate).

Inthissetting,acutinthemainrefinancingoperations(MRO)rateby25basispointsto0.5%inMay2013didnothingtoeasemonetaryconditions.Asthemarketunderstoodthatinterestratescouldnotgoaslowastheinflationobjectivedemanded,theforwardinterestcurvesteepened.Thisamountedtoaneffectivetighteningofmonetaryconditions(Rostagnoetal,2019).

Therightresponseatthispoint(ifnotearlier)wouldhavebeenfortheECBtoembarkonquantitativeeasing(QE),thatis,touseactiveoutrightpurchasesofsecuritiestolowerthelong-terminterestrate.ButtheECBhesitated(Figure3).Instead,ittriedtolowerlonger-termratesbyintroducing,inJuly2013,forwardguidanceasanewtooltocomplementinterest-ratesetting.ThismeantthattheECBstartedcommunicatingexplicitlybothitsinflationobjectiveandthepathofthepolicyinterestrateconsistentwiththatobjective,apracticealreadyadoptedbytheFederalReserveandtheBankofEngland.FortheECB,thiswasasignificantdeparturefromthepreviousprincipleto“neverpre-commit”However,long-termratesdidnotcomedown,probablybecausemarketshadbeenexpectingbondpurchasesandweredisappointedtogetforwardguidanceinstead.NotwithstandingtheECB’sattempttoguideexpectations,uncertaintyremainedhigh,asindicatedbythevolatilityofmarketreactiontoECBcommunication(seeFigure4,whichreportsmovementsoftheone-yearovernightindexedswap(OIS)ratearoundthetimeofthepressreleasefollowingtheECBGoverningCouncilmeeting).

InJune2014,theGoverningCouncildecidedtosetanegativerateonthedepositfacility,takingitfirstto-0.1%andthento-0.2%inSeptember.Theideawastocompressthetermpremiumbymakingitcostlytoholdshort-termsecuritiesandtopushbankstoshifttoholdingsoflonger-termassetsinstead.Again,thiswasnotthesolution.TheannualinflationratebecamenegativeinDecember2014andremainednegativeuntilMarch2015,twomonthsaftertheintroductionofacomprehensiveassetpurchaseprogramme(APP),includingofpublicsecurities.

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Figure3:IndexofEurosystemandFederalReserveassetsasapercentageofeuroareaandUSGDP(Q1of2000=100)

Source:BruegelbasedonBloomberg.

Thequestionis,whytwoyearsofhesitation?TheECB'sstatutesofgaveitsGoverningCouncilfullauthoritytoundertakeoutrightbondpurchasestofulfilitsmonetarypolicyobjective.Hence,theobstaclewasnotlegal'.Neitherwasitbehaviouralinertia:twoinnovativetools-forwardguidanceandnegativedepositrates-werequicklyadopted,eventhoughtheintroductionofnegativerateswasab