The cheapest and most effective firewall in the world
While the European crisis has escalated ECB officials have continued to stress that the ECB’s mandate is to ensure inflation below, but close to, 2%. Lets assume that we have to come up with a monetary policy response to the European crisis that fulfils this condition. I have a simple idea that I am confident would work. My idea is a put on inflation expectations or what we could call a velocity put. A number of European countries issue inflation-linked bonds. From these bonds we can extract market expectations for inflation. These bonds provide the ECB with a potential very strong instrument to fight deflationary risks. My suggestion is simply that the ECB announces a minimum price for these bonds so the implicit inflation expectation extracted from the bonds would never drop below 1.95% (“close to 2%”) on all maturities. This would effectively be a put on inflation. How would the inflation put work? Imagine that we are in a situation where the implicit inflation expectation is exactly 1.95%. Now disaster strikes. Greece leaves the euro, a major Southern Europe bank collapses or a euro zone country defaults. As a consequence money demand spikes, people are redrawing money from the banks and are hoarding cash. The effect of course will be a sharp drop in money velocity. As velocity drops (for a given money supply) nominal (and real) GDP and prices will also drop sharply (remember MV=PY). As velocity drops inflation expectations would drop and as consequence the price of the inflation-linked bond would drop below ECB’s minimum price. However, given the ECB’s commitment to keep inflation expectations above 1.95% it would have either directly to buy inflation linked bonds or by increasing inflation expectations by doing other forms of open market operations. The consequences would be that the ECB would increase the money base to counteract the drop in velocity. Hence, whatever “accident” would hit the euro zone a deflationary shock would be avoided as the money supply automatically would be increased in response to the drop in velocity. QE would be automatic – no reason for discretionary decisions. In fact the ECB would be able completely abandon ad hoc policies to counteract different kinds of financial distress. This would mean that even if a major European bank where to collapse M*V would basically be kept constant as would inflation expectations and as a consequence this would seriously reduce the risk of spill-over from one “accident” to another. The same would of course be the case if Greece would leave the euro. This is basically a similar policy to the one conducted by the Swiss central bank, which has announced it will not allow EUR/CHF to drop below 1.20. This mean an increase in money demand (which would tend to strengthen the Swiss franc) will be counteracted by an automatically increase in the money base if EUR/CHF would inch below 1.20. Chuck Norris to the rescue The Swiss experience clearly shows that a clearly stated and credible policy like the 1.20-target has some very clear advantages. One major advantage has been that the SNB have had to do significantly less intervention in the market than prior to the announcement of the policy. In fact the Swiss money base initially dropped after the introduction of the 1.20-target. This is the Chuck Norris effect of monetary policy – monetary policy primarily works through expectations and the market will do most of the lifting if the policy is clear and credible. There is no reason to think that Chuck Norris would not be willing to help the ECB in the case it announced a lower bound on implicit inflation expectations. In fact I think inflation expectations would jump to 1.95% at once and even if Greece where to leave the euro or a major bank would collapse inflation expectations and therefore also velocity would remain stable. This would in my view be an extremely simple but also highly effective firewall in the case of new “accidents” in the euro zone. Furthermore, it would likely be a very cheap policy. In addition there would be a build-in exit strategy. If inflation expectations moved above 1.95% the ECB would not conduct any “extraordinary” policy measures. Hence, the policy would be completely rules based and since it would target inflation expectations just below 2.0% no could hardly argue that it would threaten price stability. In fact as it would ensure against deflation it would to very large extent guarantee price stability. Furthermore, the ECB could easily introduce this policy as a permanent measure as it in no way would conflict with the over policy objectives. Nor would it create any problems for the use of ECB’s traditional policy instruments. I would of course like a futures based NGDP level targeting regime implemented in the euro zone, but that is very unlikely to find any support today. However, I would hope the ECB at least would consider introducing a velocity put and hence significantly contribute to financial and economic stability in the euro zone. PS if the ECB is worried that it would be intervening the the sovereign bonds market it could just issue it's own inflation linked bonds. That would change nothing in terms of the efficiency of the policy. The purpose is not to help government fund their deficits but to stabilise inflation expectations and avoid a deflationary shock to velocity. PPS My proposal is of course a variation of Robert Hetzel's old idea that the Federal Reserve should ensure price stability with the use of TIPS.