Author: Madis Müller

President of the Eesti Pank, Member of the Governing Council of the European Central Bank

How can monetary policy be made more efficient?

The past decade has taught the central banking community the important lesson that negative shocks can happen more frequently, and the time between the shocks may not be long enough to let central banks regain policy space.
How can monetary policy be made more efficient?

Madis Müller, President of the Eesti Pank (Foto Eesti Pank)

This leads to the question of how the efficiency of monetary policy can be maintained and improved.

The carefully planned gradual exit from accommodative policy has by now been postponed many times because new shocks have challenged the global economy. The Eurosystem faced first the Great Financial Crisis followed by the European debt crisis, then the waves of the pandemic, and now the war in Ukraine. Each negative shock has required yet another policy accommodation in both fiscal policy and monetary policy. It seems that in modern times there is only a very limited period of normalisation between the shocks, which have occurred more and more frequently. Monetary policy has seen new instruments like quantitative easing and negative policy rates deployed. And we have seen many old and new instruments used for much longer than was initially planned – the ECB first introduced a policy of negative rates in 2014, and that policy is still in place.

More bandwidth for monetary policy transmission

How efficient our standard and non-standard instruments are hinges on the efficiency of monetary policy transmission. Parallels are often drawn with the US, which has reached its inflation targets faster and without needing to bring policy rates below zero. Why does monetary policy transmission not work equally well in the Euro area? The main difference is that the European financial system is mostly bank-based, while the US also has wide and deep capital markets alongside the banking system. The dominance of bank-based financial intermediation is the main limiting factor for monetary policy transmission. While monetary policy in Europe depends heavily on the ability and willingness of the banks to supply loans, the bandwidth for monetary policy transmission in the US is much wider because the transmission channels can rely to a much larger extent also on financial markets.

The health of the banking system is critical in Europe, so Europe has clearly benefited from the progress towards a Banking Union that is based on uniform standards and uniform quality in banking supervision. Resources can only be pooled, however, if there is enough confidence between the participants, and this trust is gradually building up. The Single Supervisory Mechanism backed by the Single Resolution Mechanism has been set up and has proven its ability to supervise and manage a crisis at systemically important banks. There is still no Common Deposit Insurance Scheme, which has been called the third pillar of the Banking Union, and which is a work in process that still needs to be agreed on.

Progress in private risk sharing mechanisms has so far been less significant in Europe, even though the Capital Markets Union should be politically considerably less sensitive than the Banking Union as there is no need to pool substantial funds from the taxpayer. The focus is instead on agreeing on common standards and harmonisation, though this has also proven difficult as legal systems vary and have strong historical and cultural roots. The European capital markets consequently remain local and fragmented, and opportunities in them are limited even for medium-sized enterprises.

Technology may help

The Capital Markets Union could, however, be created even without major efforts to smooth the edges of national legislation. We could instead create a platform that is based on a relatively simple and clear set of rules. Platforms that allow for a credible exchange of financial flows already exist, and policymakers should be brave in exploring the scope of the blockchain and automated contracts. Many pages in prospectuses for issuing securities could potentially be replaced by a couple of lines of code. An algorithmic approach like this to the capital markets union could avoid a great number of legal disputes and allow progress to be made faster.

When central banks explore the possibilities offered by Central Bank Digital Currencies, they should not limit their efforts to treating the digital dimensions of currency solely as another extension of the payment system. There are many high quality payment systems in use in western countries, and a possible central bank digital currency can only be successful if it adds value to the current use cases of payment systems that are already very efficient. This means the wholesale dimension of a CBDC in particular may add value by supporting the development of the Capital Markets Union. A weekend hackathon could be organised to develop a prototype for an algorithmic capital markets union and by next Friday we might already be considerably further on with the project, having made sizable gains in monetary policy transmission.

Efficient coordination with fiscal policy

There are also opportunities for better coordination between fiscal policy and monetary policy. The major driver of volatility in inflation is often the oil price, and even larger shocks in energy prices may have become a new normal looking ahead because of geopolitical tensions and volatility in supply stemming from the increasing use of renewables. The oil price is not something that central bankers can control, but governments can use some elements in the tax system to smooth excessively high volatility in energy prices. This is a good example of how fiscal mechanisms can be designed to support price stability. The tax component in fuel prices could be made countercyclical so that the tax rate on fuel goes up when the oil price is low, and comes down when the oil price is high. Fiscal mechanisms that support price stability may gradually become more widespread. Cooperation of this type already began last winter when electricity and gas prices were elevated. Where efficient cooperation between fiscal policy and monetary policy stimulus is lacking, there is the risk of falling into the trap of ultra-low policy rates and very high public debt.

With inflation rates already far beyond the targets that are western standards, many major central banks are gradually entering an exit path from the longest period ever of monetary accommodation, which has seen a prolonged period of ultra-low policy rates and central bank balance sheets reaching record highs. The risks of rates staying too low for too long are apparent once again, with the risk that this could limit our policy space in the event of another negative shock. Having a more efficient monetary policy would let us avoid deep cuts in policy rates and gain more policy stimulus by sacrificing less policy space. The efficiency of monetary policy transmission is a critical factor for surviving future shocks in an environment that is continuously volatile.


Madis Müller, President of the Eesti Pank, Member of the Governing Council of the European Central Bank.


The article is published in a series of articles in Obserwator Finansowy written by governors of central banks and distinguished economists. The series is under the special patronage of the Governor of Narodowy Bank Polski, Professor Adam Glapiński. The authors of the articles have agreed to waive their fees for writing the texts, and in exchange NBP shall donate the amount equivalent to the fees onto the account of the National Bank of Ukraine in order to support the NBU during the war. Below is a foreword by the Governor of NBP to the whole series:


On 24 February a huge tragedy occurred, in the face of which it is impossible to simply move on as if nothing had happened.

Nobody can remain indifferent to the misfortune that has befallen the Ukrainian nation.

All of us are shocked by the press reports, and particularly by what we see in the mass media.

Fighting Ukraine is not only its brave soldiers, but also an army of thousands of civilians trying to preserve normality in a country stricken by Russian aggression.

This army includes the staff of the National Bank of Ukraine, with whom NBP is in constant contact.

Aware of our Ukrainian colleagues’ needs, we have invited several central bank governors and eminent economists to share their knowledge on the economic processes taking place around the world.

It is rare for such a distinguished group of authors to feature in Obserwator Finansowy, which is published by NBP. It is also worth underlining that all the authors have waived the fees for their articles in order to donate them to meet the needs of our colleagues working in the National Bank of Ukraine.

I believe that you will find the series of these articles interesting, especially since they not only share the knowledge and experience of their authors, but also express goodwill towards the war-afflicted NBU.

Prof. Adam Glapiński, Governor of NBP

Madis Müller, President of the Eesti Pank (Foto Eesti Pank)