News in Charts: The ECB – The Beginning of the End?

After a prolonged period of tapering, the ECB finally appears ready to draw the curtains on its quantitative easing programme. At last month’s policy meeting, the ECB announced its intention to halve the pace of net asset purchases to €15bn per month after September and to conclude net purchases altogether by the end of the year. Despite the drawn-out tapering process, which by completion will have spanned almost two years, the ECB’s asset purchase programme has not been in operation for as long as those in other advanced economies, only beginning in earnest in March 2015.

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As yet, the ECB’s asset purchases have not been sufficient to raise inflation to the central bank’s target, with headline inflation having been propped up by energy prices in recent months.

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However, in Fathom’s view the ECB’s policy stance is too loose, especially since we believe that the euro area economy is already operating above potential, with signs that significant labour shortages are emerging. The link between labour shortages and higher wages is one formulation of the Phillips Curve, a relationship which Fathom believes still to be intact. With this in mind, Fathom expects core inflation to drift higher over the remainder of 2018.

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However, given that monetary policy only affects inflation and growth with a significant lag, it is far from certain that the ECB is currently maintaining an appropriate policy stance. Many economists judge the degree of monetary stimulus in relation to interest rate rules, the most famous of which was proposed by John Taylor in 1993.[1] According to Taylor, the prevailing real policy rate is typically set with equal regard to the output gap and deviations of inflation from target. Using the IMF’s view of the output gap and the OECD’s estimate of trend growth, Fathom has calculated the Taylor rule implied policy rate for the euro area.

[1] John B. Taylor, ‘Discretion versus policy rules in practice’, Carnegie-Rochester Conference Series on Public Policy, Vol. 39, December 1993, pp. 195-214.

Strikingly, the Taylor rule appears to be a very good predictor of central bank policy over the period prior to them reaching the constraint of the nominal lower bound. More recently, however, actual policy rates have diverged significantly from what the Taylor rule would suggest. In part, this reflects the ECB leaning against other economic headwinds, such as concerns over the viability of the currency union.

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