The European Central Bank’s two pillars of monetary policy are set for performance appraisals. ECB President Christine Lagarde has promised a sweeping review of the bank’s strategy, with a separate European Parliament paper singling out its ‘two pillar’ approach for special attention. The first pillar, economic analysis, is popular and up for promotion. The second, monetary analysis, is routinely under-used and could be expelled.
The economic pillar is based on textbook relationships between interest rates, demand, output and prices. It ran out of ideas when interest rates were cut to near-zero a decade ago, but has support from friends in high places. The monetary pillar, which focuses on monetary aggregates such as M3, did not run out of ideas, but has fallen foul of its superiors. This is surprising, as M3 was a good indicator of demand over the 2010s. There were fears of a triple-dip euro area recession in late 2014. Instead, the recovery in M3’s year-on-year growth rate to 5% ushered in a period of sustained growth.
The monetary pillar has become more important in recent years because of its ability to analyse and guide unconventional policy. For central banks to create money with asset purchases, they must purchase assets from non-banks such as pension and insurance funds. Purchases from banks add to the monetary base but do not cause broad money measures like M3 to rise. The ECB was successful in this regard. During the first quantitative easing programme, the amount of government debt securities held by banks declined by €500bn while ECB holdings of government debt climbed by €1.5tn, implying a significant proportion of purchases were from non-banks.
To calculate how much QE added to M3 is straightforward. The ECB collects data to show the balance sheet of the entire euro area banking system (including the ECB) as if it were a single bank. M3 appears on the liabilities side of this balance sheet, and changes in it can be broken down into changes in the remaining items on the balance sheet – the so-called counterparts. Government bonds held by the banking system go under ‘credit to the general government’. Since normal banks reduced their holdings of government bonds over the course of the asset purchase programme, the dark blue bars shown in the chart below must be entirely due to central bank asset purchases.
The counterparts data show that QE contributed between three and four percentage points to year-on-year M3 growth while purchases were maintained at €80bn a month, accounting for most of its growth. This shows that QE was central to M3’s recovery, and that M3 was a probable factor behind the 2015 economic recovery.
There has been a lack of inflationary pressure, but this is unsurprising. M3 growth lifts demand; price pressures still depend on the interplay between demand, supply potential and the output gap. The euro area had high but falling unemployment over the period, suggesting there was plenty of slack, and while QE raised demand, it remained weak compared to pre-crisis growth rates and other developed economies.
There are other instances where the monetary pillar could have been useful – the ECB might have started QE sooner, avoided the 2011 interest rate increases and been more careful with the way new capital requirements for banks were put in place. The monetary pillar can be awkward for policy-makers who meet on a regular basis because it requires a long-term view; month-to-month changes in M3 are not a useful policy guide. However, it has its moments, and with the balance sheet replacing interest rates as the main tool of central bank policy, such moments will become more frequent.
Chris Papadopoullos is Economist at OMFIF.