The Governing Council of the European Central Bank decided to conclude its net purchases under the asset purchase programme at the end of 2018. The decision marks one of the first steps towards the normalisation of monetary policy in the euro area. Because the effects of non-standard monetary measures on the financial markets and the real economy are still uncertain, normalisation will proceed carefully and at a measured pace conditional on economic developments.

In June 2018, the Governing Council of the European Central Bank (ECB) judged that its net securities purchases under the asset purchase programme could be concluded at the end of the year. The Governing Council confirmed that it would continue to reinvest the principal payments from maturing securities even after the conclusion of net purchases.

The Governing Council also assessed that it would hold the key ECB interest rates unchanged at least through the summer of 2019. Significant monetary policy stimulus is still needed to support the further build-up of domestic price pressures and headline inflation developments over the medium term.

First steps towards normalisation measured

At its monetary policy meeting in December 2018, the Governing Council confirmed its decision to end its net purchases under the asset purchase programme at the end of 2018. At the same time, it announced it will continue reinvesting, in full, the principal payments from maturing securities purchased under the asset purchase programme for an extended period past the date when it starts raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

The Governing Council emphasised that it stands ready to adjust all of its instruments, as appropriate, to ensure that inflation continues to move towards its inflation aim in a sustained manner.

The first steps towards normalisation of Eurosystem monetary policy were thus exceedingly measured, and monetary policy was not tightened abruptly. This was also reflected in market expectations, which did not display any sudden movements in the latter half of 2018.

Effects of withdrawing non-standard measures difficult to assess

The withdrawal of non-standard policy measures will be a long process, as the euro area's outlook for growth and inflation is uncertain, and determining the appropriate stance for monetary policy is more difficult than usual.

There are a number of factors which make it difficult to assess the effects of policy normalisation. Firstly, monetary authorities have only spent a relatively brief time with non-standard policy measures. Secondly, the dynamic links between economic growth, inflation and interest rates may have changed. Thirdly, the equilibrium real interest rate in the euro area may have declined. The equilibrium rate is the interest rate at which economic growth is balanced and price developments are consistent with the ECB's inflation aim. Thus, a decline in the equilibrium rate could well result in lower interest rate levels over the medium term, when compared with previous growth cycles.

One sign of change in the dynamics of the macro economy and the transmission mechanisms of monetary policy is that, despite the recovery in growth and employment, inflation has failed to pick up as expected in the euro area and inflation expectations have slipped. Uncertainty over changes in the macroeconomic dynamics calls for a prudent approach to monetary policy.

The Bank of Finland supports regular review of the ECB’s monetary policy strategy

In addition to raising its key policy rates, the ECB has the ability to tighten its non-standard monetary policy through other means. These options, where necessary, include the ECB reducing its extensive asset purchases (which would particularly have the effect of raising long-term interest rates in the economy), reducing the amount of liquidity in the banking system, or adjusting the forward guidance on its monetary policy. On the other hand, by maintaining these measures intact it is possible to maintain an easy monetary policy stance. In any event, the Governing Council of the ECB stands ready to adjust all of its instruments, as appropriate, to ensure that inflation continues to move towards the Governing Council’s inflation aim in a sustained manner.

Therefore, many questions remain unanswered as to the scope and timing of these measures. In what order should the measures be implemented? By how much, and at what pace, should a central bank's balance sheet be reduced? How large should a central bank's balance sheet be kept, and how much liquidity should remain in the banking system under the ‘new normal’? And finally: by how much, and at what pace, should interest rates be raised?

Given these changes in the instruments and operating environment of monetary policy, it is not surprising that the monetary policy strategy has found itself facing new challenges. Under the lead of its Governor, the Bank of Finland has highlighted the need for the ECB to conduct regular reviews of its monetary policy strategy, in the manner of many other central banks.

Regular strategy reviews would bolster the success of monetary policy in the transformed operating environment and contribute to the ongoing development of European Economic and Monetary Union.

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