Ignazio Visco: Should the current monetary policy framework be
adjusted to meet (new) post-crisis challenges?
Remarks by Mr Ignazio Visco, Governor of the Bank of Italy, at the conference "The ECB and
Its Watchers XVII", debate on "Should the current monetary policy framework be adjusted to
meet (new) post-crisis challenges?", organised by the Center for Financial Studies, Frankfurt
am Main, 7 April 2016.
* * *
1. I will comment on three issues. First, is the (below but close to) 2 per cent objective
still appropriate? Second, why does inflation remain low? Do global forces dominate,
and is monetary policy still effective? Third, should financial stability considerations
interfere with monetary policy?
Is the (below but close to) 2 per cent objective still appropriate?
2. The 2003 evaluation of the ECB's monetary policy strategy considered three
arguments,1 which appear all the more valid today. All of them suggest that price
stability must be achieved and preserved through timely and effective action.
3. First, the risks of deflation and of policy rates hitting the lower bound have been
shown to be a serious issue, more than we thought in 2003. For more than one year
now we have had negative or barely positive inflation and a short-term nominal
interest rate close to its lower bound, a condition that in 2003, when we assessed
our monetary policy strategy, was considered to be very unlikely.
4. Second, there is still need to "grease" the adjustment of relative prices in the euro
area, within and especially across countries. Price and nominal wage rigidities still
exist, notwithstanding the reforms in the goods and labour markets that have been
implemented in recent years; structural differences across countries remain
considerable.
5. Third, as to the upward bias in the measurement of consumer prices, if anything,
there is more reason today to believe that this is an issue that deserves attention.
Let me quote as an example a recent article in The Economist (March 19, 2016),
reporting interesting evidence on a 'digital price index' that Adobe is developing with
the help of two academics (Pete Klenow of Stanford University and Austan
Goolsbee of the University of Chicago). The index (which is based on anonymised
sales data collected from websites that use the Adobe software) suggests that
official statistics are likely to measure the price dynamics of certain goods
incorrectly, in particular consumer technology, and, as a result, might significantly
overestimate inflation.
6. Let me also add that we should pay attention to the interactions among these (and
other) conditions. A very relevant aspect is that too low inflation for too long makes it
more difficult to deal with public and private debt. Related to this, as shown by
recent research, the interaction of falling inflation and nominal interest rates at the
ZLB with nominal debt and downward nominal rigidities can lead even favourable
transitory supply shocks (such as a reduction of the price of oil) to have negative
effects on economic activity.2
Why does inflation remain low? Do global forces dominate, and is monetary policy still
effective?
7. Low inflation certainly has a global dimension. It reflects developments in oil prices;
deflationary pressures coming from the Chinese economy; possibly technological
change. But it also reflects domestic developments that should not be
underestimated. Domestic factors operate both via expectations and via economic
activity, and in both respects conditions in the euro area differ from those in other
main advanced economies.
8. Although declining inflation expectations has been a global phenomenon, since the
end of 2014 the risk of a de-anchoring has increased particularly in the euro area,
where expectations have reached lower levels than in other advanced economies.3
A measure of this risk can be inferred from the probability that large changes in
short-term expectations will be passed on to long-term expectations.4 This indicator
climbed from October 2014 until mid-January 2015 in the euro area, while no
increases were recorded in the U.S. or the U.K. over the same period (Figure 1).
After the extension of the APP to include public sector securities the indicator
decreased sharply, but remained volatile and above the historical average.
9. Let me also point out, in this respect, that the importance of expectations of low
inflation in determining wage outcomes, and thus giving rise to second-round
effects, may be increasing. In Italy, in some recently signed collective contracts it
was agreed that parts of future pay rises will be revised downwards in the event that
the inflation rate falls short of current forecasts; according to our simulations, a
generalised adoption of this type of contract would significantly decrease the rate of
growth of wages and this would in turn be reflected in the dynamics of consumer
prices.
10. Very low inflation in the euro-area also depends to a large extent on the persistence
of economic slack and high unemployment. In the euro area the negative correlation
between unemployment and core inflation or the rate of growth of negotiated wages
is very evident even from a simple descriptive analysis (Figure 2). Supporting growth
and employment is thus crucial to bringing inflation back to target. Indeed, ongoing
work carried out at the Banca d'Italia based on micro-data suggests that after the
crisis nominal wages became more reactive to unemployment in Italy, France and
Spain; in Italy a reduction of unemployment by 3 percentage points would result in
an increase of wage inflation in a range of 0.5-1.0 percentage points.
11. But is monetary policy still capable of supporting inflation and activity? The short
answer is yes. Although we are not happy with the current outlook for inflation (and
we are also only moderately satisfied with the growth outlook) there is no doubt that
the counterfactual would have been much worse and could have led to a
deflationary spiral with severe consequences both for the real economy and the
financial sector.
12. Constructing counterfactuals is always difficult, but estimates by Banca d'Italia staff
(which do not consider possible non-linear effects) show that in the absence of the
monetary policy measures adopted between June 2014 and December 2015, both
annual inflation and GDP growth in the euro area would have been lower by about
half a percentage point in 2015-17. The expansion of economic activity in 2015
would have been slightly below 1 per cent, against an observed 1.6 per cent;
inflation would have been negative, at about -0.5 per cent, against 0.0.5 These
estimates are consistent with those of the Eurosystem and the ECB staff.6
Regarding Italy, the effects are estimated to be somewhat stronger: absent the
monetary impulse, the Italian recession would have ended only in 2017; inflation
would have remained negative for the whole three-year period.7
13. The commitment to pursuing the objective of price stability shown by the Governing
Council has been essential for stemming the de-anchoring of expectations and
maintaining the ECB credibility, which is crucial to avoiding the risk of a deflationary
spiral. When inflation remains far from target for a prolonged period, the risk of
deanchoring may be compounded by economic agents revising their expectations for
future inflation to take account of surprises registered in the past, to an extent that
also depends on the share of agents that lose their trust in the central bank's
objective.8
14. In order to bring inflation back to target, it is essential to support aggregate demand.
The unconventional measures adopted by the Governing Council of the ECB are
contributing to increased spending on consumption and investment goods. And I am
confident that the effects we have observed so far will be strengthened by the new
decisions we took on 10 March: the strengthening of the APP and the inclusion of
corporate bonds, together with the introduction of new targeted refinancing
operations, will contribute to a further decline of the cost of borrowing in the private
sector.
15. A recent debate has centred on the notion of "helicopter money". Obviously this is a
"very unconventional" policy, targeted at directly affecting consumption and
investment by households and firms. Such an extreme measure would undoubtedly
be subject to operational and legal constraints; the redistributive implications and the
close ties with fiscal policy would all make it very complex, all the more so in the
euro area given its institutional framework. As recently noted by President Draghi,
and reiterated by Benoît Coeuré and Peter Praet, helicopter money is not currently
part of the discussion in the Governing Council, although no policy tool within our
mandate can or should be dismissed a priori.
16. This discussion is noteworthy, not much per se, but because it underlines the
concern that monetary policy is left to act in isolation. Indeed, the fact that monetary
policy is still effective does not mean that it can support macroeconomic stability on
its own. In order to achieve satisfactory growth, it needs to be complemented by
budgetary policies aimed at creating appropriate macroeconomic conditions, as well
as by further reforms aimed at increasing potential output growth. In the past years
of crisis, monetary policy has bought time for the decisions in other spheres of policy
making, but beyond a certain limit such a role would inevitably run into unintended
consequences.
Should financial stability considerations interfere with monetary policy?
17. My reading is that it is important to consider the implications of monetary policy for
financial stability, but that financial stability depends on adequate nominal growth. It
is thus dangerous if monetary policy fails to pursue its own targets. As highlighted in
the latest (November) Financial Stability Review of the ECB, banks' profitability and
debt-sustainability continue to be challenged by a weak economic recovery.
18. Are concerns for financial instability - due to the very accommodative monetary
policy - currently justified in the euro area? It does not seem so. Indicators of
imbalances in housing and credit markets do not point to increasing vulnerabilities in
the euro area as a whole: estimates of over-valuation of residential property prices
do not signal widespread risks (Figure 3), and the financial cycle is still negative
(Figure 4). Of course, aggregate data may mask heterogeneous developments
across and within countries. But in the event of risks in specific sectors and/or
countries, appropriate macroprudential measures can be implemented to limit their
accumulation.
* * *
19. A protracted, very accommodative monetary policy involves risks which need to be
monitored carefully, and low or negative nominal rates for too long may hurt some
institutions. But the current low level of interest rates in the euro area is not a bizarre
choice of the Governing Council of the ECB; rather, it reflects the slack in the
economy and dangerously low actual and expected inflation. A less accommodative
monetary policy in the current circumstances would be harmful to everyone. The
only sustainable way to raise nominal rates is to strengthen growth and job creation.
These are necessary conditions for bringing inflation back to target and preserving
price stability in the interest of all euro-area citizens. And this is why we need to be
ambitious in our decisions. The stronger our actions today, the sooner these
conditions will be fulfilled.
Indicator of co-movement between short/long-term inflation
expectations for extremely negative variations
Note: The indicator is based on the probability of co-movement of long-term and
shortterm inflation expectations. It is calculated as an odds ratio over a rolling window of 250
working days; an increase indicates a closer link between large reduction in short-term
and long-term expectations. See F. Natoli and L. Sigalotti, "An indicator of inflation
expectations anchoring", Banca d'Italia, Temi di Discussione (Working Papers),
forthcoming.
Figure 2
Core inflation, negotiated wages and unemployment in the euro area
Source: European Central Bank and Eurostat. Note: core inflation excludes energy and
unprocessed food.
Over/undervaluation of residential property prices in the euro area
Source: European Central Bank, Financial Stability Review, November 2015.
Note: over/undervaluation estimates are based on four different methods, two statistical
and two model-based. A positive figure indicates overvaluation, i.e. prices above
longterm average (in the case of statistical models) or fundamental values (in the case of
economic models).
Figure 4
Domestic credit-to-GDP gap in the euro area
Source: European Systemic Risk Board and Banca d'Italia's calculations.
Note: the credit-to-GDP gap is calculated as the deviation of the ratio of total credit to
nominal GDP from its recursive one-sided Hodrick-Prescott trend. GDP-weighted
average of euro area country gaps.