Yves Mersch: Remarks at the "Challenges in Understanding the
Monetary Transmission Mechanism" conference
Remarks by Mr Yves Mersch, Member of the Executive Board of the European Central Bank, at
the "Challenges in Understanding the Monetary Transmission Mechanism" conference, Warsaw,
22 March 2019.
* * *
Should we radically rethink the role of cash to deal with the lower bound on interest
rates?
The lower bound on interest rates has been a major challenge for central bankers in the multiple
crises over the last ten years. It threatens the effectiveness of monetary policy by preventing it
from steering financial conditions. Moreover, the continuous decline in both the real rate and
confidence in the central bank, as well as resistance at the retail level, raises the question of
whether negative rates should be part of the standard toolkit of central banks.
In the context of the Eurosystem's asset purchase programmes, the combined package of
negative nominal interest rates and lending schemes that incentivise banks to increase lending
(e.g. the targeted longer-term refinancing operations, or TLTROs) have been an effective and
appropriate way to combat these challenges. While cash represented the largest part of central
bank balance sheets before the crisis, other elements of the balance sheet have since gained
more prominence in the operational framework of monetary policy.
Some people want to abolish cash by taking advantage of recent technological advances, such
as distributed ledger technology (DLT), or replace public money with private money, in total
denial of people's trust in liabilities issued by central banks and the fact that their continued
demand for cash exceeds GDP growth. Others argue for the introduction of a dual currency
scheme where the central bank would divide the monetary base into two separate local
currencies - cash and electronic money (e-money). E-money would be issued only electronically
and would pay the policy rate of interest, and cash would have an exchange rate - the
conversion rate - against e-money, which could be manipulated to match negative rates on
1
emoney by setting the conversion rate for cash lower than one to one.
I have experienced the nightmare of dual exchange regimes before the euro and I have doubts
about these arguments. Our unconventional measures have proven sufficient to meet the
challenges of low inflation. The Governing Council has confidence in the sustained adjustment in
the path of inflation. Recent evidence supports the hypothesis that there is some substitutability
2
between conventional and unconventional monetary policies.
Additionally, while being able to set significantly negative rates may work smoothly in an
economic model, I am less certain how the general public would react, particularly after millennia
of positive nominal rates. Not only would such rates be deeply unpopular, there may also be
unintended changes in behaviour that could dampen the effectiveness of the measure.
3
The fact that banks do not pass negative rates on to most depositors, and notably not to
households, is a warning sign for central banks of how people may react if attempts were made
to extend the lower bound of rates downwards by replacing cash with some form of remunerated
digital currency. What assets the central bank ought to hold against these widely held liabilities
driving bank disintermediation and deleveraging?
A potential decision to issue a central bank digital currency (CBDC) needs to be assessed in
relation to the impact on the financial system. In an extreme case, during a systemic banking
crisis, holding risk-free central bank-issued CBDC could become vastly more attractive than
bank deposits. There could be a sector-wide run on bank deposits, magnifying the effects of the
crisis.
Even in the absence of a crisis, readily convertible CBDC could crowd out bank deposits -
putting the two-tier banking system at risk. Then, the efficient flow of credit to the economy would
likely be impaired. The central bank - now holders of deposit funding - would have to decide
which projects to finance, either directly, by replacing commercial banks, or indirectly, by
deciding which banks would receive funding. This would lead to a situation in which the central
bank pretends to know better than the established system of the decentralised allocation of
credit.
Overall, there is currently no convincing motivation for the Eurosystem to issue CBDC to the
general public. It is unnecessary and appears to be disproportionate to the aims put forward by
its proponents. There is no need to fix something that is not broken. If anything, one could
imagine a digital representation of cash that replicates the features of cash in the reasonably
distant future, if people demanded it. And I have not even mentioned the insufficient robustness
or reliability of some technologies like DLT, or their energy insufficiencies and dependencies.
How does technological change affect the monetary transmission mechanism and
monetary policy?
Technological change has multifaceted effects on the transmission mechanism. It is important
not to jump to conclusions, for example that, because the Phillips curve has become flatter,
monetary policy needs to be more aggressive. Let me add that, beyond technological changes,
additional liquidity demand factors also stem from regulatory change, fragmentation and the fact
that the banking union is incomplete.
I will consider how technological change affects the following three broad channels of monetary
transmission, without focusing on the consequences structural changes will have for the
operational framework:
1. How policy rates affect market interest rates and financial conditions.
2. Labour markets and the non-accelerating inflation rate of unemployment (NAIRU).
3. Price-setting and the Phillips curve.
Financial innovations have the potential to impact the way the economy is financed
A change from bank-based to market-based financing has been taking place for some time in the
euro area, partly related to financial innovation. This has led to firms having a more diversified
financing structure and has improved their resilience to shocks emanating from the banking
system. At the same time, corporate exposure to volatility in market rates has increased.
Fintechs can lead to further bank disintermediation, but also financial deepening, by allowing
4
otherwise constrained households and firms to borrow. In addition, fintech can strengthen
unregulated lending activities, posing challenges to financial stability. This might affect the
transmission mechanism, although how it will do so is not yet clear.
Labour markets and the NAIRU
The possible disruption from technological change is likely to be felt in labour markets. Email,
5
videoconferencing, secure VPN connections and outsourcing across countries all enable
services to be provided from a distance, and permit a greater degree of flexibility in working
practices - a massive socioeconomic shift.
In the labour market the internet enables more services to be offered with less intermediation at
lower prices. Fragmentation of labour time is shown in the diverging results of compensation per
employee and compensation per hour worked.
For some workers this is a positive development, allowing them to participate in the workforce
6
where previously they were excluded. For others, the greater individualisation can lead to
insecurity, affecting households' income. More individualised roles can also weaken the power of
7
collective bargaining to maintain the labour share of income.
While the productivity-enhancing aspects of digitalisation might tend to raise potential output
growth, the effects operating through labour and capital are more uncertain, and might even work
in different directions.
There may be some substitution of labour for capital, with possible repercussions for the
bargaining power of workers, and a shift in investment to the IT sector as a result of digitalisation
and servicification. If there is a skill bias in the transition to digital technology, this could lead to a
greater mismatch in labour markets, and therefore a higher NAIRU and lower potential output
growth.
On the other hand, digital production and supply chains, and digital communication and
connectivity, would tend to lower the NAIRU and raise potential output, because of the
productivity increases resulting from faster collection and evaluation of data, and the greater
efficiency of digitally underpinned production.
The overall effect of digitalisation and new technologies on demand and supply therefore
depends on many factors. These include the initial conditions: economies with high-quality
institutions and governance are likely to see faster adoption and implementation of digital
technologies and a faster impact on potential output.
From a monetary policy perspective, it is important to monitor the digital transformation of the
economy. Some economists argue that output, productivity, intangible investment and prices
have become more difficult to measure as a result of digitalisation. Literature suggests that, even
though some mismeasurement exists, its impacts may not necessarily be greater than in
8
previous episodes of technological change.
But the analysis is ongoing, with various opinions and sometimes conflicting results. Of course,
the fast pace of change across all areas of the economy also requires us to update our tools for
monitoring it, and leverage the opportunities modern technology gives us, including new and
better data.
Price-setting and the Phillips curve
Technological progress poses a particularly acute challenge because of its direct impact on
businesses' price-setting behaviour; behaviour that directly underlies the inflationary process.
The growing importance of e-commerce, rapid product introduction and substitution, and the
quality adjustment of new products also pose their own challenges for measuring inflation.
Technological progress has resulted in the creation of products such as smartphones and
internet service providers that had no equivalent in the past; failing to properly measure the
quality improvements in new products can result in an upward bias in measured inflation. On the
other hand, the reduction in shelf-life of many products and the heavy discounting of
9
lessfashionable older versions could instead create downward bias in traditional price indices.
Technological changes to price and wage-setting behaviour have much deeper relevance for
central banks than just the measurement of inflation. The speed and extent of how inflation
reacts to shocks affects the optimal monetary policy response:
E-commerce may result in suppliers changing prices more frequently. Not only are
Amazon's prices more flexible than prices of brick-and-mortar stores, Amazon's
competitors are forced to adjust prices more often for products that are also offered by
11
Amazon. More frequent price changes result in a steeper Phillips curve - prices react
more quickly and strongly to changes in costs and output. This could also mean that inflation
12
reacts much faster to monetary policy.
Since online stores effectively offer the same price across locations, e-commerce may
restrict the ability of businesses to set prices that deviate substantially from those of large
online retailers while reflecting local conditions. So prices may change more often, but they
may be more uniform, which in turn may restrict the ability of prices to reflect idiosyncratic
13
and regional shocks.
E-commerce changes not only how firms set prices but also how consumers shop. It has
revolutionised the transparency of pricing both within and across countries, allowing
consumers to easily compare prices and swap one product for another. This can result in
higher demand elasticities, eroding the monopolistic and monopsonistic power of suppliers
and reducing mark-ups. Profit margins at Amazon (less than 4%) are much lower than at
14
Walmart (more than 20%). Such a change in demand elasticities and mark-ups can be
viewed as a flattening of the Phillips curve.
Finally, the emerging prevalence of e-commerce can create new opportunities for
consumers to switch their shopping outlets over the business cycle. For example, there is
evidence that households actively exploit price differentials across stores and "trade down"
in recessions (e.g. switch from a regular grocery store to a discounter). It could be predicted
that this switching will be amplified in the future because switching to an online store is
particularly easy. As a result, aggregate "true" inflation may be more cyclically sensitive than
15
is suggested by headline inflation.
The impact of e-commerce on the slope of the Phillips curve is uncertain, and studies have
generally struggled to find large effects on annual inflation. Given the overall difficulty in estimating
the slope of the Phillips curve, this is not entirely a surprise.
Conclusions
As with measuring consumer price indices, the greater availability of more granular data has
enabled a much greater understanding of how businesses set prices. But while policymakers
should adapt policy to take into account changes in the underlying price-setting process, we
should also exercise due prudence, given the uncertainty surrounding model estimates.
Price stability-oriented monetary policy needs to monitor innovations and their impact on financial
conditions, economic growth and inflation. And we have to be mindful of changes in the
information content of the indicators that central banks use as a basis for policy decisions (e.g.
monetary aggregates and inflation rates).
As the impact of innovations cannot be estimated in advance with sufficient certainty regarding
the direction, size and duration of the effects, and uncertainty therefore prevails, monetary policy
should act prudently and be forward-looking.
See Heider, F., Saidi, F. and Schepens, G. (2018), "Life below zero: Bank lending under negative policy rates",
Review of Financial Studies, forthcoming.
4
See Eichenbaum, M., Rebelo, S. and Wong, A. (2018), "State Dependent Effects of Monetary Policy: the
Refinancing Channel", NBER Working Paper No 25152; and Faia, E. and Paiella, M. (2018), "P2P Lending:
Information Externalities, Social Networks and Loans' Substitution".
5
VPN = Virtual private network.
6
Bloom, N., Liang, J., Roberts, J. and J. Zichun (2015), "Does working from home work? Evidence from a
Chinese Experiment", Quarterly Journal of Economics, 130(1): 165-218 find a 13% increase in productivity of
workers who work from home.
7
International Monetary Fund (2017), "Understanding the downward trend in labor income shares", IMF World
Economic Outlook, April.
8
See for example Brynjolfson, E., Rock, D., Syverson, C., (2018), 'Artificial Intelligence and the Modern Productivity
Paradox: A Clash of Expectations and Statistics', chapter 1 in The Economics of Artificial Intelligence: An
Agenda, NBER, Gordon, R.J. (2018), 'Declining American Economic Growth despite Ongoing Innovation',
Explorations in Economic History, vol. 69, pp. 1-12, Mokyr, J. (2018), 'The past and the future of innovation: Some
lessons from economic history', Explorations in Economic History, vol. 69, pp. 13-26.
9
The direction of the bias for the aggregate index is less certain. In Broda, C. and Weinstein, D. (2010), "Product
Creation and Destruction: Evidence and Price Implications", American Economic Review, Vol. 100(3), pp. 691-
723, the authors find that failing to take into account product creation across the index creates an upward bias to
traditional "fixed good" indices.
10
Gorodnichenko, Y. and Talavera, O. (2017), "Price setting in online markets: basic facts, international
comparisons and cross-border integration", American Economic Review, Vol. 107(1), pp. 249-282, January.
11
Cavallo, A. (2018), "More Amazon Effects: Online Competition and Pricing Behaviour", NBER Working Paper No
25138, presented at the Jackson Hole Symposium 2018.
12
Nevertheless, early evidence suggests that online prices are as unresponsive to macroeconomic shocks as
offline prices - see Gorodnichenko, Y., Sheremirov, V. and Talavera, O. (2018), "The responses of internet retail
prices to aggregate shocks: A high-frequency approach," Economics Letters, Vol. 164(C), pp. 124-127.
13
In Cavallo, A. (2017), "Are online and offline prices similar? Evidence from large multi-channel retailers",
American Economic Review, Vol. 107(1), pp. 283-303, the author finds price levels are identical around 72% of
the time.
14
Gorodnichenko, Y. (2018), Discussion of Cavallo, A., Jackson Hole Symposium 2018.
15
See Nevo, A. and Wong, A. (2018), "Measuring inflation in the modern economy - a micro price-setting view",
ECB Forum on Central Banking.