ECB monetary toolkit constantly evolving

In the aftermath of the Global Financial Crisis, central banks vastly expanded their toolkits in order to continue fulfilling their mandate. In addition to the regular rate setting policy, they have added new instruments such as asset purchase programmes and targeted lending operations to banks. This has resulted in a considerable expansion of the Eurosystem's balance sheet, with a concurrent increase in the potential side-effects of the policy. Now that central banks have started to scale back stimulus measures in response to high inflationary pressures, a new phase has begun. The new instruments are being rolled back, but will remain available down the road. In addition, central banks will continue to respond to new developments such as digital currencies and the emergence of non-banks, and will adjust their instruments accordingly and where necessary.

Monetary operations are geared towards price stability

The objective of the ECB and most other central banks is to maintain price stability. However, central banks do not directly influence the prices of goods and services in the economy. Through financial markets and banks, monetary operations have an indirect effect on interest rates paid by companies and households, and subsequently on economic activity. This process by which monetary operations ultimately affect inflation and economic growth is known as monetary transmission.

How monetary instruments are used depends on the desired monetary policy stance. This policy stance indicates the extent to which monetary policy is aimed at easing economic conditions (stimulating the economy) or tightening them (slowing down the economy). Based on actual or expected economic developments, central banks set the desired policy stance, which is then translated into one or more operational target variables. These are variables such as short-term market interest rates that a central bank can reliably control from day to day through its monetary operations.

What instruments do central banks have at their disposal to set the policy stance?

For a long time, monetary policy was primarily aimed at steering short-term interest rates to achieve the desired policy stance. However, in response to exceptional crisis conditions – the Global Financial Crisis, the European debt crisis and the COVID-19 crisis – and a period of persistently low inflation, central banks worldwide have developed and deployed a series of new instruments in order to continue fulfilling their mandates. Indeed, the scope for further monetary easing through regular interest rate policy was limited as interest rates came close to or even fell below zero after a structural decline in recent decades. Central banks have therefore supplemented their monetary toolkits with four types of instruments:

• Expansion of lending operations, which provide credit to banks. Originally, these operations were only intended to provide liquidity to the money market and steer short-term interest rates. Since the Global Financial Crisis, however, extensive operations have also been in place to support bank funding and lending to the economy.
• Direct asset purchases to support financial markets and reduce capital market rates. Interventions in specific markets, for example in vulnerable countries during the European debt crisis, were necessary to support transmission. In addition, the ECB has employed quantitative easing: large-scale asset purchases to reduce long-term interest rates and thereby ease financial conditions.
• Negative interest rate policy to expand the scope of the traditional interest rate instrument and remove the perception among market participants that interest rates are capped at zero.
• Forward guidance as a communication tool to provide information on future monetary policy intentions.

Whereas conventional interest rate policy focuses on the policy stance, the new instruments are primarily aimed at reinforcing monetary transmission (Figure 1).

Figure 1: Monetary operations and the transmission mechanism 

The instruments in the toolkit can be adapted if necessary

The new instruments have been successful in many respects: panic in the financial system has been contained and lending stayed on track during the COVID-19 crisis. Although inflation remained below the 2% target for a long time, a real deflationary trend was also avoided. At the same time, there are also caveats. For instance, there has been a logical and commensurate increase in the risks for central banks, and the measures may have undesirable side-effects on market forces and financial stability. This means that the costs and benefits must be carefully weighed when deploying these new instruments.

A new phase started last year, with inflationary pressure rising sharply for the first time in decades. This calls for a normalisation of monetary policy along with the phasing out of stimulus measures. In the meantime, net asset purchases have been discontinued, the key policy rate is no longer negative and the ECB has minimised the use of forward guidance because of the current high levels of uncertainty. Moreover, a new stabilisation instrument (Transmission Protection Instrument, TPI) has been announced to counter excessive interest rate rises in specific markets. This range of instruments in the toolkit is aimed at bringing inflation back to target and limiting unwarranted, disorderly market dynamics that pose a serious threat to monetary policy transmission.

It should be noted, however, that the ECB does not have full control over economic developments and inflation, as evidenced by the long period of low inflation over the past decade and the current rate of inflation, which is very high. Structural changes such as globalisation and other policy areas such as fiscal policy and wage and price policy also influence inflationary trends. Partly in response to these external factors, the monetary toolkit is constantly evolving in order to enable central banks to fulfil their mandate as effectively as possible. In addition to the new questions regarding the deployment and phasing out of unconventional instruments to deal with the current high level of  inflation – a process in which the ECB has hardly any experience – further adjustments to the toolkit may be needed down the road in response to issues such as climate change, the development of digital currencies and the rise of non-bank finance.

The Occasional Study The Eurosystem’s monetary toolbox in unconventional times presents a comprehensive discussion and explanation of the evolution of the ECB's monetary operations.