The ECB has changed

In the wake of the financial crisis, the ECB has noticeably changed its behaviour and its reaction function and monetary policy has undergone a structural break. Whereas in the first decade of the central bank’s existence there was still a close alignment between economic development and monetary policy orientation, the last ten years have seen an increasing decoupling of monetary policy from real economic events. One reason for this lies in the asymmetrical reaction function of the currency guardians. In economic downturns the ECB reacts faster and more strongly than in upswings. This was particularly noticeable both in the fading financial crisis and in 2015, when the ECB announced its entry into the PSPP despite the upswing, but out of concern about deflationary risks.

Despite the zero interest rate policy and the extensive use of unconventional measures, the ECB has not yet succeeded in halting the trend of falling inflation expectations. The primary objective of monetary stability has largely been missed for years, which is evidence of the low efficiency of monetary policy instruments. The reason for this is that structural factors have a disinflationary effect, which the ECB itself can hardly influence.

Although the effectiveness of monetary policy instruments is limited, the side effects on the financial market are all the greater. Although the trend of declining capital market yields has been observed for more than 20 years, the ECB’s bond purchase programme has further accelerated the decline in yields. In 2019, at its peak, about one third of the outstanding bonds even showed a negative market yield. The low interest rate environment is primarily generating crowding-out effects. Investors are being squeezed out of low-interest forms of investment and are moving into higher risks and/or longer maturities. Investors are willing to accept ever lower risk and maturity premiums in order to avoid negative returns, if at all possible. Meanwhile, the average duration of outstanding EMU government bonds continues to rise. The index duration of the iBoxx € Eurozone has reached a new record level of 8.5 years in 2019. In view of the low interest rate environment, the importance of the rolldown, which at least still provides a small return, is also increasing. On the other hand, some investors are likely to take a more positive view of the implicit volatility, which has declined since the beginning of the PSPP.

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