European Central Bank

The massive programmes of government bond buying have led to a fundamental change in the operating procedure of the major central banks. The latter now operate in a regime of abundance of bank reserves. This makes it impossible to raise the money market rate except by increasing the rate of remuneration of bank reserves. This, in turn, leads to a massive transfer of the central banks’ profits to commercial banks that will become unsustainable. We argue that the remuneration of bank reserves is not inevitable and that there is an alternative to the current central banks’ operating procedure that avoids making profit transfers to private agents. We propose to use minimum reserve requirements as a policy tool to achieve this objective. Our favoured proposal is a two-tier system of reserve requirements that would only remunerate the reserves in excess of the minimum required. This would drastically reduce the giveaways to banks and allow the central banks to maintain their current operating procedures.

While a new Bretton Woods-style agreement is highly unlikely, the US and Europe should help update the existing monetary system with a new set of best practices and norms.
Many of the seemingly ‘established’ norms of monetary policy are in fact quite recent, having emerged since the breakdown of the Bretton Woods system in the 1970s. These norms include inflation targeting, central bank independence from political authority, and the separation of monetary policy from regulatory activity such as bank supervision. Central bank orthodoxy has also, until recently, largely ignored the international ‘spillover’ effects of monetary policy.
The 2008–09 financial crisis and its aftermath changed the picture. Monetary policy was recruited to assist governments in stabilizing financial markets and restoring liquidity. And conventional assumptions about the primacy of central banks’ responsibility for price stability were challenged as quantitative easing (QE) proved less inflationary than feared. Indeed, eight years after the crisis, the inflation rate – the most significant driver of monetary policy under the old regime – remains consistently low in most major economies.
In this context, the United States faces some unique challenges. The dollar’s status as the global reserve currency means that the US Federal Reserve’s decisions often have international ramifications. Emerging markets are becoming more exposed to spillovers from US policy, as globalization renders their economies and financial systems more interdependent and as finance becomes increasingly important relative to other economic activity.
In Europe, the euro’s problems reflect similar shortcomings to those that undermined the 1944 Bretton Woods system. Launched in 1999, the euro was in effect an attempt to maintain fixed exchange rates between member states. However, the single currency’s designers underestimated the difficulty of maintaining such a system across multiple national economies, each with different growth profiles and fiscal policies. The euro’s structural problems have been exacerbated by the secular shift from a world of politically ‘subservient’ central banks, as existed before the creation of the European Central Bank (ECB), to the current system in which the ECB is highly independent.
Despite the current strains on the monetary system, consensus on a formalized new international framework in the mould of Bretton Woods is unlikely. A more plausible outcome is the organic development of a new set of norms articulating principles both for the mechanisms by which central banks pursue price stability and for the governance of central banks themselves. The United States and Europe are likely to be at the forefront of this process. They should proactively shape the new norms to ensure that they meet the challenges of today’s evolving economic landscape.