Dr. Michael Heise, Allianz
Inflation Targeting and Financial Stability

Over the last decades, government bond yields have been falling drastically in advanced economies along with long-term interest rates. In his Working Lunch, Michael Heise, chief economist at the insurance group Allianz, scrutinized recent developments in monetary policy and suggested building a broader index of price stability.

According to Heise, the general rule of thumb that the long-term bond rate should correlate with long-term growth of GDP no longer holds true. “Monetary policy and not fundamental factors has put down interest rates”, Heise said. Looking at the negative side effects of a low-interest rate environment, Heise warned against a situation as in Japan that suffered a balance sheet recession after a financial crisis. In Japan, the accumulation of non-performing loans (NPL) inhibited banks from giving new loans and zombie firms were kept alive.

Furthermore, as a consequence of the current low-interest rate environment in the euro area, asset prices and especially housing prices have been increasing. Simultaneously, risks were building up in investors' portfolios. According to Heise, the BBB components in investment grade indices were continuously rising. “Investors are going up the risk ladder, searching for yields”, Heise said. Imbalances are also building up in the target system.

Comparing the unconventional monetary policy measures of the European Central Bank (ECB) and inflation development, Heise concluded that “inflation has its own life”. In his opinion, the ECB should define price stability targets in a more adaptable way, moving the focus away from a simple year-on-year target for consumer price inflation.

Instead of relying exclusively on the Harmonised Index of Consumer Prices (HICP), Heise suggested building a broader index which also reflects inflation expectations. In Heise’s opinion, since in a financial boom risks are building up that could hit back when the economy is slowing down, the ECB should also put greater weight on developments in the financial cycle. According to Heise, “this is quite difficult and requires tough decisions but they need to be taken”.

Inflation Targeting and Financial Stability (PDF)