ECB's Constancio Says the Old Normal Is Gone for Central Bankers

(Bloomberg) -- Vitor Constancio has a message for his successors at the European Central Bank: their job will look very different from his.

The vice president, whose term ends this month, set out his thoughts for the future of monetary policy in a speech in Malta on Friday. In a nutshell: The emergency measures deployed during the crisis are here to stay, and a return to the “old normal” is effectively impossible.

“It is somewhat doubtful that monetary policy can remain effective just by going back to the traditional approach of very small central-bank balance sheets and the targeting of overnight money market rates.”

Constancio, who also oversees the ECB’s research, listed some of the concepts and instruments that future monetary policy makers may have to wrestle with:

Large Balance Sheets Are Here To Stay

Liquidity drives such as bond-buying programs by major central banks have caused their balance sheets to balloon -- at 4.6 trillion euros ($5.5 trillion), the ECB’s assets are equivalent to more than 40 percent of the euro area’s economic output.

The U.S. Federal Reserve is leading the way in gradually shrinking its holdings, but Constancio said keeping balance sheets at a “significant” size would offer several benefits. Those include influencing a broader range of market interest rates than the traditional short-term borrowing costs that central banks target, and providing a repository of safe assets that investors can access.

The vice president also noted a related idea: Greater steerage over market rates would extend its influence to some extent to non-banks, such as insurers and investment funds, that are playing an ever-larger role in funding the economy.

Be Ready To Review Inflation Targets

Setting a target for inflation and tweaking short-term interest rates has been the standard central-bank approach for decades. It largely worked to ensure stable, predictable prices for businesses and households -- until the financial crisis. Since then, stubbornly low inflation has tested the credibility of central-bank stimulus.

Constancio said he has no theoretical objections to “mild corrections” to inflation targets. He rejected raising them outright but cited a proposal floated by former Fed Chairman Ben Bernanke: make up for lost inflation during a crisis by letting prices rise faster for a bit. This overshooting -- known as price-level targeting -- would give the economy, and therefore policy makers, some breathing room before the next downturn hits.

Beware the Natural Rate

Constancio also cast doubt over a key tenet of monetary policy -- the idea of a natural rate of unemployment at which inflation takes off.

The link is embedded in the so-called Phillips curve which shows an inverse relationship between unemployment and wage growth, and it’s become pretty wobbly in the post-crisis world. Constancio cited academics who see the jobless rate only partially capturing how much spare capacity is left in an economy. Some wonder whether the curve is still valid at all.

Constancio said the curve remains valid but that “policy makers should seriously consider the possibility of dropping” the idea that a natural rate can be estimated.

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