Dutch governor warns of unconventional policy hazards

Netherlands Bank governor Klaas Knot has argued the European Central Bank should become much more cautious about the use of unconventional monetary policies.

The Dutch governor’s latest intervention comes as the ECB prepares to review its monetary policy structure. Knot also gave two major speeches in New York in October setting out his vision for reforms of the eurozone’s economic framework.

Knot repeatedly stressed that central bankers had much less understanding of unconventional policy tools than of their conventional equivalents. “Monetary policy may wish to display more inertia – by which I mean caution or carefulness – in deploying policy instruments on those fronts where our knowledge is less developed,” he said.

Central bankers did not fully appreciate the effects of less conventional policy tools, “both in phasing-in and the phasing-out”, he said. “A more inert approach by the central bank is also warranted if the nature of shocks and frictions in the economy cannot be clearly identified.”

Some unconventional tools had worked in promoting growth and inflation, he told the European Banking Institute in Frankfurt on November 14. But he cautioned that this had been true in very particular circumstances.

Knot said that in the past, eurozone inflation had been below the ECB’s target of close to but near 2% because of “a lack of accommodative financial conditions”. But now, he said, the ECB’s monetary policy made sure that finance was accommodative.

Inflation was staying low for other reasons, including “a declining trend in some of the underlying components of inflation”, Knot argued. “At this juncture, one might argue that financial conditions are not really an impediment to economic activity and for inflation to increase.”

He also warned that eurozone monetary policy was likely to be weak unless it was backed by expansionary fiscal policy and structural reform. The transmission of monetary policy was likely to be weakened where banks suffered from “a lack of capital or the persistence of legacy assets on banks’ balance sheets”. If policy-makers could resolve those problems, he said, that could reinforce ECB policies like its targeted long-term refinancing operations (TLTRO).

Knot also warned that persisting with unconventional monetary policies for too long could have unwanted effects. He cited a 2018 paper by Markus Brunnermeier and Yann Koby that warned prolonged negative policy rates could lead to a “reversal rate”. Knot said this was “the level of the interest rate below which the negative effects on the banking sector start outweighing the positive effects.”

If that happened, Knot said, “lowering rates further may actually imply that monetary transmission becomes impaired”. This, he noted was “an environment that policy-makers do not want to venture in”.

Knot differs with Weidmann

Knot has emerged as one of the more hawkish members of the ECB’s governing council in recent months. On September 13, Knot sharply criticised the ECB’s return to sovereign bond purchases and its deepening of negative policy rates. His comments mirrored many points made by Deutsche Bundesbank president Jens Weidmann, who other ECB governing council members describe as Draghi’s most consistent internal critic.

But Knot’s criticisms of ECB policy are in several ways significantly different from those made by Weidmann and other senior German officials. He argued in an October 16 speech the ECB should consider making its inflation target formally symmetrical. The current target commits the ECB to achieving eurozone inflation close to, but under, 2%.

Knot said the ECB could gain more flexibility in the face of external shocks by formally adopting “a symmetric band around the inflation aim, which would buy the central bank time and flexibility in responding to forces it cannot control”. 

This statement put Knot’s views close to former ECB president Mario Draghi, who argued that the ECB’s approach to inflation was “symmetrical” in his monetary policy statement in July. Draghi said the ECB was equally unwilling to tolerate long-term deviations above or below its inflation target.

But Weidmann used an August speech to strongly dismiss Draghi’s view: “Regarding our definition of price stability, the current formulation of the target is not symmetric in my view.”

“But we had a discussion about symmetry, and there is a sense in the governing council that there should be a reflection on the objective: namely is it is close to but below 2%, or, should we move to another objective?” 

Knot also differs from German officials on his view of the need for fiscal stimulus in the eurozone. In his most recent speech, he again called for more expansionary fiscal policies by eurozone governments with the space to implement them.

Former ECB president Mario Draghi and other leading ECB officials have called repeatedly for looser fiscal policy in recent years. But the German governments led by Angela Merkel have opposed such a turn. Senior Bundesbank officials led by Weidmann have expressed doubts over how effective looser monetary policy would be.

The Dutch central bank governor also endorsed a eurozone-wide deposit insurance scheme in his October 16 speech. Senior German policy-makers have consistently said they oppose such a measure unless eurozone governments end the practice of giving the same risk-weighting to all eurozone sovereign bonds.