COMMENTARY PIECE – ECB: supporting inflation and the green transition.

Article link: https://www.ft.com/content/2190afb2-3666-4416-895d-1ab22e290b3f

During this crisis, the EU has demonstrated it can react quickly to external shocks. Just one month after the spread of the Covid-19, the ECB decided to create the Pandemic Emergency Purchase Program, with a total amount of €1,850 billion. This, of course, has the objective to release the pressure on governments and allow them to run deficits in order to face the pandemic, without worrying about a potential increase in the interest rate of their sovereign bonds. During the financial and the sovereign debt crisis, the ECB took a relatively long time before implementing non-conventional instruments and for Mario Draghi to pronounce his famous “within our mandate, the ECB will do whatever it takes”. The former part of this sentence is crucial: the ECB is in charge of monetary policy and, at the time, it was unsure what instruments it could use and if they were within its powers.

By article 123 TUE, the ECB cannot directly finance government or other national or subnational bodies, but since the financial crisis these boundaries has been stretched. With the certification of legitimacy by the European Court of Justice, the ECB could pursue its quantitative easing via the Asset Purchase Program, which most consistent part is consisting in the Public Sector Purchase Program, a government bond-buying scheme to increase the money supply and reach the inflation target. This move was made to buy time for governments to implement reforms and recover from the crisis, and it worked for almost every member of the Eurozone. At the present moment, the ECB has to deal with 2 major issues, beside the current pandemic: inflation and the green transition.

The inflation target has not been reached for some time now. Set to be "close, but under 2%" over the medium term, the average inflation rate in the eurozone from 2015 up to now has been under 1%, despite the huge volume of the Asset Purchase Program for a grand total of €2900 billion. There are different views on what the ECB should do regarding its inflation target. Some would simply adjust the target rate at “close, but under 1%”, but this would mean that the PSPP, which primary reason of existence was to reach that target, would not continue. Hence, the ECB would embark in selling program which could potentially cause an increase in the interest rate of sovereign bond of certain countries who have still difficulty in putting their debt to GDP ratio under control.

Elaboration on Eurostat data.

One of the reasons the Asset Purchase Program has not work properly is embedded in the structure of the Eurozone itself: these is one monetary policy for 19 different fiscal policies. Since the inflation measured at the Eurozone level is the average of the index in 19 countries, some Member States face a much lower or a much higher inflation than the target. To avoid this kind of discrepancy, the EU should converge toward a common fiscal policy, since there has been plenty of evidence that the Stability and Growth Pact, as well as the so-called “two-pack” and “six-pack”, has not been able to make the various economy converge. One monetary policy cannot have the same effect of 16 different fiscal policies.

Source: Eurostat

If the quantitative easing had not work for the past 5 years, the idea of expanding it further in size seems more like a political move than one provoked by the concern of inflation: it is clear, at this point, that monetary policy alone cannot provide the necessary impulse to increase the harmonize consumer price index. The general low level of interest rates alone has proven too not to be enough to drive increase in aggregate demand. Thinking the ECB has the power to deal alone with the problem affecting the eurozone is impossible, governments have to work in tandem with the central bank so that fiscal and monetary policy can reinforce each other and be more effective together. When dealing with inflation, it is often forgotten by commentators that the money supply is just one of many aspects that can determine the level of prices. It would be unfair to say that the ECB is the only actor to blame in this picture: governments also have their fair share of responsibility. The need for cooperation between these two areas has become evident and crucial, especially in a non-optimum currency area.

For what concerns the green transition, the ECB had already decided to make eligible green bonds not only as collateral for credit operation in the EU system, but also for the direct purchase for monetary policy purposes. In this regard, the ECB could go as far as favor this type of bond in its buying scheme to put an incentive on this kind of investment and companies, breaking, therefore, its principle of “market neutrality”. This could be the first step towards a financial system more aware and responsible for the challenges posed by climate change. A further step could be the implementation of climate risk in the stress tests of banks, because many industries, in the near future, will have to face the problems connected to the environment and the shift of national and international policies towards a more environmentally friendly legislation that could potentially make them suffer heavy losses, hence possibly causing trouble for the banks.

But, as with the problem of inflation, it is governments who have the primary responsibility and have the best tool to achieve this goal. As Mario Draghi frequently said, the ECB has done and can do just one part of the job, the other is in the hand of governments who decide fiscal policy and can enact reforms to tackle the various issues occurring each time. Therefore, the proposal of coordinating the monetary and fiscal policy could be a favorable solution to some problems affecting the Eurozone.