Monetary expansions and price level gaps

Conventional wisdom holds that the US Federal Reserve is much more proactive than the ECB. In this sense, comparisons are often made between the aggressive monetary expansions enacted in the US to counter the effects of the Global Financial Crisis (GFC) in 2007-09 and more recently of the Covid-19 pandemic and the hesitant reactions of the ECB to the same shocks and to the Eurozone Debt Crisis of 2010-12.

The evidence shows, however, that the ECB's monetary expansion, as measured by the size of the monetary base as a ratio to GDP, is now far greater than that of the Fed (see Chart 1). Having lagged the US in the aftermath of the GFC and of the Eurozone Debt Crisis, the eurozone monetary base grew faster than in the US since the ECB launched its QE in early 2015. Moreover, the ECB has applied negative interest rates since June 2014, and today offers refinancing to the banking sector at a rate that can be as low as -1%. In contrast, the Federal Reserve has never reduced interest rates below zero, thereby limiting the potential decline in the real interest rate.

Chart 1. Monetary base (% of GDP)

Source: Refinitiv and EFGAM calculations.

Estimates of “shadow” short-term rates also suggest that criticism of the ECB may not be fully justified. These shadow estimates attempt to quantify the impact of unconventional monetary policies - including negative interest rates, asset purchases, and forward guidance - in terms of the level of short-term interest rates.¹ Although there is uncertainty about the level of shadow short-term rates for the eurozone, estimates put them clearly below the estimated level for the US (see Charts 2a and 2b).

Chart 2a. Shadow rates estimates - US

Chart 2b. Shadow rates estimates - eurozone

Source: Reserve Bank of New Zealand, Federal Reserve Bank of Atlanta, and Refinitiv.

For central banks aiming for an inflation rate of around 2%, a better measure of policy shortfall is, arguably, the gap between the current price level from that consistent with the target inflation rate. Graph 3 shows that the percentage distance to the target price level, taking January 1999 as the starting point of the calculation, is about two percentage points higher in the eurozone than in the US. To make matters worse, the eurozone price level gap is set to widen in coming years according to ECB staff projections that inflation will be well below 2% until at least the end of 2023.

Chart 3. Price level gap

Source: Refinitiv and EFGAM calculations.

Although the intensity of unconventional monetary policies may on some measures appear greater in the eurozone than in the US, the larger gap accumulated by the current price level compared to that consistent with the inflation target suggests that the ECB should have been more aggressive. To compensate for the persistent undershooting of the inflation target, monetary policy in the eurozone looks set to remain more expansionary than in the US for the foreseeable future.

¹ Such shadow rates are estimated by central bank economists such as Leo Krippner of the Reserve Bank of New Zealand and Cynthia Wu and Fan Dora Xia of the Federal Reserve Bank of Atlanta. See Reserve Bank of New Zealand Comparison of international monetary policy measures and Federal Reserve Bank of Atlanta Center for Quantitative Economic Research.