José Manuel González-Páramo: The ECB's monetary policy during the
crisis
Closing speech by Mr José Manuel González-Páramo, Member of the Executive Board of
the European Central Bank, at the Tenth Economic Policy Conference, Málaga,
21 October 2011.
* * *
Introduction
Ladies and Gentlemen,
It is a great pleasure for me to be here and to discuss with you the ECB's monetary policy
during the crisis. I wish I could talk about the financial crisis in the past tense. The last time I
had the opportunity to talk about these issues in Malaga was, when I had the honour of
receiving the title of Doctor Honoris Causa from this prestigious university in June.
Unfortunately, since then, the sovereign debt crisis has reached a new intensity. As you may
know, this has led the Governing Council of the ECB, in its recent meeting on 6th October, to
adopt additional monetary policy measures in the form of a commitment to continue the
fixed-rate full allotment policy at least until the middle of 2012, the allotment of two long-term
refinancing operations of approximately 12 and 13-months maturity, as well as a second
Covered Bond Purchase Programme. These measures complement the active
implementation of the Securities Markets Programme which the Governing Council decided
upon at the beginning of August in response to the intensification of the sovereign debt crisis.
Apart from these non-standard measures, the Governing Council, however, also decided to
leave the interest rate applied in our main refinancing operations unchanged.
I would thus like to use the opportunity of delivering the closing speech to this conference, to
reflect on our monetary policy objectives, the challenges posed by the on-going financial and
economic crisis for monetary policy, as well as the different standard and non-standard
measures we have adopted; and how they relate to each other.
Monetary policy objectives
Price stability
As regards objectives for monetary policy, for the ECB there is one which trumps all others:
price-stability. This is the primary objective which euro area governments have delegated to
the ECB as an independent central bank, and which is enshrined in the Treaty on the
Functioning of the EU. The achievement of price stability is thus what we are accountable
for, before anything else.
While the ECB is bound to the primary objective of price-stability, it was left to the ECB to
define price stability. Since the start of the euro in 1999, we have defined price stability as a
level of inflation of below but close to 2% over the medium-term.
What we have achieved, from the first of January 1999 until the end of this September, is an
average inflation rate of around 2.0%. Let me emphasise that this period includes the
financial crisis which started in the summer of 2007, which has already entered its fifth year.
Despite these challenging times, the record in delivering price-stability is outstanding and
stronger than that of any of the national predecessors of the ECB. An average inflation rate
of around 2.0% testifies as much to the success of the euro as a currency, as to the ECB as
its central bank.
The monetary policy transmission mechanism
The pursuit of price-stability requires an effective monetary policy transmission
mechanism. When the monetary policy transmission mechanism functions, then decisions
on the official interest rate, in the case of the ECB the minimum bid rate in main refinancing
operations, appropriately affect inflation and economic activity through various channels, in
line with the established standard empirical relationships.
The starting point of the monetary policy transmission mechanism is the overnight interbank
market. From there, interest rates are transmitted along the yield curve, also through the
formation of expectations, to longer-term interest rates. Furthermore, banks and other
financial market participants, pass on money market interest rates to households and
businesses, thereby affecting economic activity.
In what follows, let me focus on three market segments which, in the euro area, are
particularly relevant for the monetary policy transmission mechanism. These segments have
been specially important during the financial crisis and this is why our monetary policy
measures have focused on them: first, the interbank market; second, the covered bond
market; third the sovereign debt market.
The interbank market
Let me start with the interbank market. In normal times, the Eurosystem calibrates the
amount of central bank liquidity it provides to banks in its refinancing operations in order to
meet the liquidity needs of the system as a whole. The aim of this calibration is to equalise
the probability of banks being either short or long in central bank liquidity on the last day of
the reserve maintenance period. If that is achieved, the price for central bank liquidity in the
interbank market should lie half-way between the marginal lending and the deposit facility
rate: in other words it should be similar to the MRO rate. Intertemporal arbitrage assures that
also in previous days of the maintenance period, the overnight rate equals the MRO rate.
A key pre-condition for interbank markets to work smoothly is, however, that banks lend to
each other and that liquidity flows smoothly between market participants. Central bank
liquidity provision is based on banks' aggregate liquidity needs. If liquidity does not circulate,
then the appropriate liquidity supply is very difficult to calibrate. More than that, if some
banks' access to the interbank market is impaired, these may have to pay very high rates. As
a result money market rates may rise significantly above the MRO rate, thereby impairing the
starting point of the monetary policy transmission mechanism.
Covered bonds
Well-functioning securities markets more generally play a crucial role in the monetary
transmission mechanism. The second market I would like to discuss is the most important
privately issued bond segment in euro area capital markets, namely covered bonds.
Covered bonds represent a central funding source for euro area banks and, as you may
know, in contrast to other currency areas, banks are the main source of credit in the euro
area. As a result, conditions in the covered bond markets are an important determinant of
banks' ability to extend credit to their own customers.
Sovereign bonds
With regard to the third market segment which I would like to discuss, sovereign bonds, we
can distinguish at least three ways in which they affect monetary policy transmission. First,
the price channel: As a "risk-free rate", sovereign bonds have traditionally served as a
benchmark, indeed a floor, for the interest rates banks charged for loans, and for the pricing
of other financial contracts and securities. Indeed, due to their supposed "risk-free" property,
the holding of government bonds as liquid assets is generally rather encouraged by
regulators. This is especially true also for the new liquidity risk regulation proposed as part of
Basel III. Second, the balance sheet channel: changes in prices of government bonds affect
the balance sheet value of securities held for trading, or for sale. Finally, there is the liquidity
channel, through which government bonds have become the prime source of collateral in
interbank lending.
Other objectives?
Beyond price-stability and the maintenance of the transmission mechanism, can the ECB
pursue monetary policy objectives other than price-stability? While the Treaty of the EU
establishes price stability as the primary and overriding objective of monetary policy, it also
states that without prejudice to price stability, the ECB shall "support the general economic
policies of the Community" and "act in accordance with the principle of an open market
economy with free competition, favouring an efficient allocation of resources". The Treaty
also mentions that the ECB shall "contribute to the smooth conduct of policies pursued by the
competent authorities relating to the prudential supervision of credit institutions and the
stability of the financial system."
At various points of the financial crisis, including the present juncture, financial stability has
been at risk. What does this mean for the ECB in practice? As laid down by the Treaty, there
is a lexicographic ordering of objectives: price stability comes first: if this is granted, then the
ECB may contribute to financial stability. Therefore, there can be no question of trading off
price stability against financial stability. Indeed, price stability is a necessary condition for
financial stability and thus the best contribution monetary policy can make to financial
stability.
Note, however, that even with price-stability guaranteed, the ECB should only contribute to
the smooth functioning of the financial system. Financial stability is a responsibility of
governments, while our responsibility is price-stability. Indeed, if governments respond
appropriately to risks to financial stability and banks reinforce and efficiently restructure their
balance sheets, the ECB may have to be less concerned with non-standard measures to
restore the monetary policy transmission mechanism.
Against the background of our objectives of price-stability and the monetary policy
transmission mechanism, let me now turn to the origins of the financial crisis.
The financial crisis and monetary policy measures
We can distinguish two major episodes in the current crisis, first the sub-prime crisis,
magnified by the collapse of Lehman Brothers, and, second, the sovereign debt crisis in
whose thrall we still find ourselves.
Mispricing of risk
The two episodes share some common causes. During the so-called "great
moderation" - growth was steady, inflation low, and the slicing, dicing and distributing of risk
had supposedly made financial markets more efficient and resilient - but what had in fact
occurred was that risk had been mispriced. The risk of sub-prime mortgages and the
financial products built around them was grossly underestimated. The same occurred with
sovereign bond markets, as only small differences in risk premia could be observed in the
euro area, despite significantly diverging debt and deficit dynamics in the different member
states.
Subsequently, both in sub-prime and sovereign debt markets risks became over-priced with
markets quickly becoming one-sided as a result of contagion and extreme risk aversion.
Underlying the crisis is thus a significant fragility of security markets, which calls into question
the efficiency of financial markets more generally.
From the sub-prime to the sovereign debt crisis
At least three aspects of the sub-prime crisis contributed also to the current sovereign debt
crisis. First, the sub-prime crisis weakened banks' balance sheets, which were still under
repair when the sovereign debt crisis came to a head in May 2010. Second, the fiscal
support given to banking systems and significant spending packages worsened public debts
and deficits. Third, the Lehman bankruptcy left confidence in the robustness of the financial
system severely dented.
The root cause of the current crisis, however, lies within the shores of the euro area.
Nonetheless, with the internal and external value of the euro holding up well, this is certainly
not a crisis of the euro but a sovereign debt crisis focused on some euro area sovereigns.
Two things, however, have gone wrong: First, some countries have accumulated debts and
deficits, which at a minimum make them vulnerable to self-fulfilling unsustainable dynamics.
Second, the Stability and Growth Pact was effectively suspended when France and Germany
escaped sanctions for breaching the debt and deficit criteria in 2003. More generally and at a
deeper level, the governance of the economic union, which should complement the monetary
union, has been insufficiently articulated since the outset of EMU.
The standard tool: the official interest rate
What has been the role of monetary policy in this context of economic and financial crisis?
Let's start by first looking at what is often referred to as conventional monetary policy. The
standard and most important tool of monetary policy is the official interest rate, in the case
of the Eurosystem the minimum bid rate in the weekly main refinancing operations. Although
we characterise this tool as "standard", the financial crisis did require significant and
aggressive cuts in interest rates: following the collapse of Lehman Brothers the ECB
lowered, within a period of seven months, the refinancing rate by 325 basis points from
4.25% to a historic low of 1%. The rate was kept at this historically low level until April 2011
when the Governing Council decided to increase the rate by 25 basis points. This was
complemented by another rate increase to the current level of 1.5%, which the Governing
Council decided to maintain at its last meeting of 6th October.
The financial crisis has required the ECB to go beyond the standard interest rate policy. Let
me now turn to the three market segments, I have mentioned earlier: the interbank market;
the covered bond market and the sovereign debt market.
Interbank market
The sub-prime crisis made itself felt in interbank markets at the beginning of August 2007
when overnight rates started trading at unusually high spreads to the MRO rate. This
reflected some banks' perceived need to hedge against adverse liquidity risk. The collapse of
Lehman then transformed the money market tensions into a full-blown crisis as a vicious
circle of increased liquidity and credit risk brought interbank trading to a virtual halt. Money
markets meanwhile became extremely segmented according to specific bank names: the
uncertainty surrounding holdings and values of mortgage-related financial products shut
specific counterparties out of the interbank market.
In the sovereign crisis, segmentation is arguably an even more significant problem, as it
occurs normally by jurisdiction. Banks generally exhibit home bias in their public debt
holding: as a result, counterparties' ability to trade cross-border in the interbank market
becomes increasingly correlated with the perceived riskiness of their sovereign.
In response to the segmentation of interbank markets, the ECB adopted several measures
which essentially replace the missing intermediation in the interbank market by increasing
intermediation through the central bank: first, the fixed-rate full allotment policy; second,
LTROs with 6-month and 12-month maturity; third: foreign currency operations; fourth: a
further broadening of the collateral framework. Let me take them in turn.
While the money market tensions in August 2007 were addressed with a few fixed-rate full
allotment tenders with overnight maturity, with effect from 15 October 2008, we introduced
the fixed-rate full allotment policy in all our refinancing operations for the different
maturities. Under fixed rate full allotment counterparties have their bids fully satisfied, against
adequate collateral, and on the condition of financial soundness. The fixed rate full allotment
policy has proven a very efficient way of offsetting liquidity risk in the market by ensuring
banks' continued access to liquidity. It is also a very flexible tool, as counterparties can
themselves control the amount of liquidity they demand. Thus, a falling demand for liquidity
can be seen as a sign of normalisation.
The fixed-rate full allotment policy is probably the most significant non-standard measure the
ECB is implementing. At its latest meeting on 6th October the Governing Council, in
response to a worsening of liquidity tensions in the market, has committed to maintaining the
fixed-rate full allotment policy until the middle of July 2012.
The fixed-rate full allotment policy has been complemented by 6-month and 12-month
operations. These operations serve to further reduce the funding risk faced by the banking
system over a longer time horizon. They were an important tool following the Lehman
collapse. Whilst in late 2009 it had been decided to phase them out, in August of this year
the Governing Council decided to re-introduce such operations by conducting one 6-month
operation and more recently to allot one operation of approximately 12-months and one of
approximately 13-months which will reach the beginning of 2013.
As a third element of our non-standard measures, the international cooperation of the
major central banks has been crucial: especially the swap arrangements with the US Federal
Reserve which have allowed us to conduct fixed-rate full allotment tenders in US dollars
which are aimed at repairing impaired money markets in foreign currency. These operations
have been instrumental following the collapse of Lehman, while during the course of 2010
demand in these operations petered out. As a precautionary measure, the ECB has
nonetheless recently decided to re-establish 84-day fixed-rate full allotment tenders in
US dollar, in addition to the 7-days tenders.
Finally, our response to the crisis has included an extension of our eligible collateral list. The
main aspects of the Eurosystem's collateral framework are the following: that we accept a
very broad range of eligible assets; that a broad range of counterparties can participate in
our refinancing operations; that the same type of collateral is accepted in all refinancing
operations; and that we have common eligibility criteria across the euro area, with
losssharing in case of a counterparty default.
Having a framework that already accepted a wide range of collateral before the crisis, which
in the case of the euro area is due to the original need to accommodate a very diverse
financial system, has served as a key crisis-mitigation tool. Especially important is the
possibility to increase the liquidity of assets and counterparties in times of stress. It is worth
noting that the financial crisis led other major central banks to significantly broaden the
collateral framework for their open market operations.
By contrast, the Eurosystem only had to make relatively minor adjustments to its collateral
framework. Let me give you two examples: in October 2008, we started to accept some
foreign-currency ABS against euro area collateral. Furthermore, credit thresholds on
marketable assets (except ABS) were lowered from A- to BBB.
A further response to the sovereign debt crisis relating to changes in our collateral framework
has been to suspend the application of the minimum credit rating threshold for outstanding
and new marketable debt instruments issued or guaranteed by the Greek, Irish and
Portuguese governments, all of which are implementing EU and IMF programmes.
It should be emphasised, however, that our collateral framework is flexible. As part of our
traditionally conservative risk management approach, we have also tightened some
requirements in the course of the crisis. For instance, the eligibility of foreign-currency ABS
was revoked on the first of January of this year and ABS rating requirements have been
tightened more generally. For example, we now require newly issued ABS to have at least
two AAA ratings, when they are issued, in order to be eligible in our operations.
Central bank intermediation as automatic stabiliser
Both our fixed-rate full allotment policy and our broad collateral framework have the
properties of automatic stabilisers with regards to financial market turbulences. The term
"Automatic stabiliser" is usually applied to features of tax and transfer systems which tend to
offset fluctuations in economic activity without the need for discretionary fiscal interventions
by policymakers. However, both our fixed-rate full allotment policy and our collateral
framework smooth out the demand for liquidity in a similar automatic way.
Consider fixed-rate full allotment against broad collateral: If demand is high, liquidity
provision is high and within the bound of the standing facilities corridor, money market rates
fall, reducing tensions. By contrast, if demand for liquidity declines, money market rates rise
again towards the MRO rate and become less accommodative. In addition, if financial market
tensions have a negative effect on certain market segments, like the covered bond and ABS
markets, our collateral framework can help improve the liquidity conditions for these
securities by accepting them as eligible collateral.
Moving on from interbank markets let me now turn to the covered and sovereign bond
markets.
Covered Bond Purchase Programme
One of the innovative responses of our operational framework was the launch of our first
Covered Bond Purchase Programme (CBPP1) in July 2009. This initiative had four
objectives: first, reducing money market term rates; second, easing funding conditions for
credit institutions and enterprises; third, encouraging credit institutions to maintain or expand
their lending to households and enterprises; and, fourth, improving market liquidity in
important segments of private debt securities markets.
The CBPP was announced in May 2009 and € 60 billion of covered bonds were purchased
from July 2009 to July 2010. The programme was successful in restarting activity in primary
covered bond markets. However, with the recent intensification of the sovereign debt crisis,
covered bond markets have again come under significant pressure. At its meeting of 6th
October, the Governing Council therefore decided to announce a second covered-bond
purchase programme, CBPP2, within which €40 billion will be bought within the year starting
November 2011. CBPP2 shares with CBPP1 the objective of easing funding conditions and
encouraging institutions to maintain or expand lending, as well as supporting market liquidity
in private debt security markets.
Securities Markets Programme
The fact that sovereign bond markets in some euro area jurisdictions were becoming
increasingly dysfunctional by May 2010, and considerations over the crucial role that this
segment plays as a basic pillar of our financial system, motivated the launch of one of our
most important non-conventional monetary policies to date: the Securities Markets
Programme (SMP). The main purpose of this programme is maintaining a functioning
monetary policy transmission mechanism by promoting the functioning of certain key
government and private bond segments.
Impairment of the monetary policy transmission mechanism caused by tensions in
government bond markets can be significant. This can happen, firstly, via the price channel,
as the role of the "risk-free rate" as a pricing benchmark is distorted. Falling values of
sovereign bond portfolios also affect banks' balance sheets, and reduce, through the liquidity
channel the value of government bonds as collateral. In addition to this, excessive volatility of
bond prices can also force investors to sell-off their bond holdings and make it more difficult
for market makers to do their job. All these channels affect banks' and other participants'
ability to play their role in transmitting our interest rate policy because they negatively affect
their intermediation role and can cause a contraction in the supply of credit.
The SMP should, of course, be clearly distinguished from the policy of quantitative easing.
While the objective of the SMP is to repair the transmission mechanism, quantitative easing
aims at injecting additional central bank liquidity in order to stimulate the economy. As a
result, quantitative easing, as for instance with the Bank of England, comes with precise
quantitative targets. By contrast, the size of SMP purchases is driven by an intervention
strategy which seeks to improve market functioning. Let me stress that the liquidity injected
through SMP purchases is re-absorbed on a weekly basis so as to specifically neutralise the
programme's liquidity impact.
It is important to note that with its contribution to the monetary policy transmission
mechanism, the SMP, in conjunction with the SMP-liquidity absorbing operations, is oriented
towards price-stability. Thus, the SMP is very much an innovative tool with an orthodox
stability-oriented purpose.
Standard and non-standard measures: complementary or independent of each other?
How can we best characterise the relation between standard and non-standard
measures? In terms of our decision-making we follow a separation principle. This means
that there is no pre-determined sequence of standard and non-standard measures. For
instance, in April 2011 the Governing Council raised the MRO rate before having phased-out
all the non-standard measures. Similarly, at its most recent meeting the Governing Council
decided to keep the main refinancing rate unchanged, while, firstly, expanding our
nonstandard measures by re-introducing LTROs with 12-months and now even 13-months
maturity, and, secondly, announcing a second covered bond purchase programme.
As the discussion of non-standard measures has shown, these measures are not, however,
necessarily separate from the standard interest rate policy, but rather complement it. While
the monetary stance is signalled through the main refinancing rate, and non-standard
measures are directed towards maintaining the monetary policy transmission
mechanism, standard and non-standard measures complement each other in the
pursuit of price-stability , which is the mandate that our fellow European citizens entrusted us
with in the EU Treaty.
Concluding remarks
Let me briefly conclude by highlighting that the segmentation of interbank markets is a
reflection of the segmentation of sovereign bond markets and of the debt crisis which afflicts
some euro area jurisdictions. Our most significant non-standard measure is without doubt the
fixed-rate full allotment policy, which provides central bank intermediation where the
interbank market fails and which operates in a very quiet manner. Although this policy can
moderate the symptoms of the crisis, it cannot provide the lasting solution to this crisis. This
solution will require the decoupling of banks' fortunes from the funding situation of their
sovereign. In light of recent developments, swift recapitalisations of banks in a coordinated
fashion will prove crucial. A lasting solution to the sovereign debt crisis must tackle its root
causes. To this end, the affected countries must improve their fiscal adjustments and
implement structural measures aimed at promoting growth. In addition to this, the euro area
will also need to develop economic governance which is effective. More generally,
governments also have to step up more decisively to preserve financial stability, which is
their responsibility.
If banks', following appropriate policy actions on the above mentioned fronts, are no longer
mistrusted because of their holdings of sovereign debt, the segmentation of money markets
will decrease significantly. Then the need for adopting non-standard measures would
disappear. And I would need to steal less of your time to discuss the monetary policy of the
ECB. Time is certainly not something we have in plentiful supply, given the immense
economic policy challenges that countries like ours have ahead of them on their way out of
the crisis.