In reality, the effects of monetary, economic and fiscal policies are difficult to separate. More importantly, in most cases, these policies are mutually reinforcing, rather than conflictual. A fiscal expansion has a bigger impact when monetary policy is very accommodative because it avoids that rising interest rates act as a headwind. Inaction in terms of structural adjustment –a point which was emphasized by Mario Draghi as ECB President in every single press conference during his mandate- increases the burden on monetary policy. Likewise, insufficient fiscal stimulus during a downturn puts the entire burden on monetary policy. This implies that the proportionality of monetary policy needs to be assessed taking into consideration the stance of economic and fiscal policy.
Another factor to be taking into account is the risk of non-linear developments. This is top of mind when a central bank wants to preserve its inflation targeting credentials: throwing in the towel could put us into deflation, with detrimental economic consequences. Another example is maintaining adequate market functioning, including for governments. This is a key objective of the Pandemic Emergency Purchase Programme3. The relationship between policy effort and risk was clearly emphasized by ECB President Lagarde in last week’s press conference: “That some self-imposed limits might hamper action that the ECB is required to take in order to fulfil its mandate, the Governing Council will consider revising them to the extent necessary to make its action proportionate to the risks that we face.”4 Following the publication of the judgment, the spread between Italy and Germany widened somewhat, but, all in all, the reaction was muted. Investors must have considered that countless press conferences, meeting accounts, speeches and working papers should make it an easy task for the ECB to demonstrate that its PSPP is proportionate. In reaction, the ECB issued a press release in which it took note of the ruling adding it remains fully committed to its mandate to ensure “that the monetary policy action taken in pursuit of the objective of maintaining price stability is transmitted to all parts of the economy and to all jurisdictions of the euro area.” The emphasis on ‘all jurisdictions’ is no coincidence and is a subtle reminder that the large geographic remit is another factor to take into account what is proportionate and what not.
The assessment whether monetary policy in pursuing its inflation objective is proportionate needs to take into account the stance of economic and fiscal policy, the necessity to have adequate transmission to all jurisdictions as well as the likelihood and extent of tail risks due to insufficient policy action.
Whereas the Constitutional Court’s judgment could raise concerns that the interpretation of the ECB’s mandate could be narrowed, thereby weighing on the effectiveness of monetary policy, the spring forecast of the European Commission emphasized the downside risks to its bleak assessment of the outlook and underlined once again to do more and act collectively. It mentions the risk of a revival of concerns about debt sustainability –which supports the necessity of the PEPP- but also the importance of sufficient coordination of national policy responses. The common EU response could be too limited “or be inadequate to compensate for the lack of sufficient policy space in those euro area Member States that are also hardest hit.” This last point brings another aspect of proportionality into the picture: in a monetary union, a condition for fiscal policy in a given country or at the union-wide level to be proportionate is that it takes into account whether it sufficiently compensates for the absence of policy leeway in certain member states. To conclude, the assessment whether monetary policy in pursuing its inflation objectives proportionate needs to take into account the stance of economic and fiscal policy, the necessity to have adequate transmission to all jurisdictions as well as the likelihood and extent of tail risks due to insufficient policy action. In addition it seems useful to apply such an assessment to fiscal policy in the context of a monetary union.
