Yves Mersch: Behaving responsibly in a low interest rate
environment - a central banker's perspective
Speech by Mr Yves Mersch, Member of the Executive Board of the European Central Bank, at
the Stiftung Marktwirtschaft: Expertentagung "5th Kadener Gespräch", Alveslohe, 10 February
2017.
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The policy of the European Central Bank (ECB) is often said to be at the root of the current
problems in the banking and financial sector. Particularly in Germany, there's the added
accusation of monetary policy "expropriating" savers.
A closer look quickly reveals that such hasty judgements fail to appreciate the complexity of the
matter. Today, therefore, I shall examine carefully the underlying reasons for our monetary policy
action. By focusing on the reasons for our actions we can understand more easily how to get
back to a normalisation of monetary policy.
Low natural interest rates
Why are interest rates so low?
The growth trend has been declining in many mature economies not just since the crisis, but for
several decades. This slowdown in growth has led to lower long-term interest rates.
The structural causes of this trend of slowing growth is a subject of controversy among
specialists. Demographic and technological developments are mentioned, as are the effects of
the financial cycle, which may be out of sync with the business cycles. I do not want to pre-empt
this ongoing discussion. Instead, I would like to focus on two issues, which in the current context
are very relevant from a monetary policy perspective - regardless of the structural causes
underlying the weak economic growth.
First, the slowdown in growth in this environment increased the risk of a self-reinforcing
downward spiral. For the weak growth dynamics will not go unnoticed by economic actors: their
expectations are worsening. If, for instance, a company expects demand to fall, it will be less
inclined to make big investments.
Secondly, ageing societies, which exist in many mature economies, not only have to cope with a
shrinking labour force, but they also have to save more. This has led to a savings glut and to a
shortage of safe assets. So investments are falling and savings are rising. This weakness of
investment is further reinforced when public authorities invest less than is even needed to
preserve the capital stock. This is a cause for concern especially where both fiscal space and
demand exist.
This dynamic has led to a reduction in the natural interest rate, i.e. the real rate of interest in
which savings and investments are in equilibrium in an economy operating at its potential, where
there is neither upward nor downward pressure on inflation.
In the current environment, the ECB has brought the market rate below the level of the natural
rate. The key rate since March last year has been at zero and the rate on the deposit facility at -
0.4%.
Had we not done this, constant nominal interest rates amid falling inflation rates would have led
to higher real interest rates and undermined anaemic growth even more. This would have
significantly increased the risk of deflation. This is just as harmful as accelerating inflation. As
Walter Eucken said: "Deflation distorts the price framework just as much."1
Thus, price stability for the ECB means that we have to protect European citizens not only from
inflation rates that are too high, but also from a deflationary spiral. This is reflected in our
quantitative definition of price stability: an inflation rate of below, but close to, 2% in the medium
term.
We therefore acted in order to abide by this symmetrical mandate on price stability.
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But we are aware that we cannot lower our interest rates to an unlimited extent. As from a
certain level, it becomes more attractive to keep cash - despite the associated costs - than to
pay negative interest rates. And even if this point has not yet been reached, we are bearing in
mind that further rate cuts into negative territory may have non-linear effects. The reactions of
people in extremis cannot be anticipated.
But we can also influence market interest rates in other ways. Thus, for example, with our asset
purchases we have pushed the yield curve down. And by offering targeted longer-term
refinancing on favourable terms which reward additional lending, we have made it possible for
banks to cut their interest rates, a move which has led to increased lending.
All these measures in recent years have contributed to the economic recovery in the euro area.
Thus, both the demand for, and supply of, credit is rising.
In the real economy, too, positive surprises have predominated recently. The growth rate in the
fourth quarter of last year rose to 0.5 %. In the euro area, the seasonally adjusted unemployment
rate fell to 9.6% in December. In November it was 0.1 percentage point higher and in December
of the previous year it was still at 10.5%.
Overall, the prospects for economic growth in the euro area are increasingly positive. However,
while the data within the monetary union is pointing to growth risks being more and more in
equilibrium, uncertainty and the risk of political shocks outside continental Europe have clearly
gone up.
To put it another way: while the economic outlook for the euro area is steadily brightening, dark
clouds are building up on the political horizon beyond the continent.
But of course we shall pay particular attention to how prices evolve. The annual rate of inflation
rose, according to provisional estimates by Eurostat in January, by 0.7 percentage point to 1.8%.
This sharp jump in the rate of inflation is largely attributable to volatile components, namely
energy and, to a somewhat lesser extent, food. Core inflation, on the other hand, which excludes
food and energy, remained stable at 0.9%.
For us, the overall inflation rate is the key figure because we protect the purchasing power of
citizens, albeit in the "medium term", not on a month-to-month basis. Given the current high
variability of energy prices, indicators of the underlying price dynamics say more about future
developments than about the overall inflation rate.
We still assume that, because of energy prices, the overall inflation rate will rise until the middle
of this year - reaching our "comfort zone". But one swallow doesn't make a summer. For in the
second half of the year, it is likely to fall again and then reach 1.5% in 2018.
So, subdued inflation will be with us for quite some time, but the spectre of deflation has
disappeared from the radar of market participants.
For this recovery to gain traction, we have to keep our word. The adjustments to our asset
purchase programme will be implemented as announced in December - because, first, it
contributes significantly to the economic recovery and stabilisation on the price front. And
second, monetary policy in times of heightened uncertainty must be a guarantor of stability and
reliability by being credible.
And yet, at the same time, how much longer can we continue to talk about "even lower rates" as
being a monetary policy option? Considering the importance of credibility for a central bank, as
mentioned, there should be no delay in making the necessary gradual adjustments to our
communication.
But support from the political dimension is needed too. Structural reforms are required in various
areas as well as fiscal stimulus where budgetary flexibility exists.
And what sounded like a platitude yesterday risks being forgotten today: political stability, the rule
of law and reliability are essential conditions for maintaining our prosperity. And only open
markets and free trade make it possible to boost this prosperity. We need to make the cake
bigger, instead of squabbling over the existing portions. Protectionism will only lead to a loss of
prosperity for all.
Impact of monetary policy on banks
We are aware that our measures have side effects and that these become more pronounced the
longer the unconventional measures last. Let me emphasise that these measures are temporary
and are not a permanent part of our active toolbox.
To mitigate risks as far as possible, we closely monitor the broader repercussions of our
monetary policy. We carefully watch insurance companies, pension funds and, above all, banks,
which play a key role in the transmission of our monetary policy.
Let's first of all take a look at the banks: over the longer term abnormally low or negative interest
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rates, together with a very flat yield curve and negative term premia, can have adverse effects.
Those banks whose business depends heavily on maturity transformation and on deposit-based
refinancing are being hit particularly hard. And as it is difficult to pass negative interest rates onto
retail customers and as the introduction of fees provides only limited remedy, some of the banks
will have to adapt their business models. Also, consolidation will continue to be necessary to
increase efficiency in the long term.
We are now already seeing that concerns about the future profitability of banks are affecting their
share prices. The euro area bank index fell by around 40% between August 2015 and August
2016. This decline was driven by, among other things, a worsening outlook for the global
economy and growing concern about the effects of the low interest rate environment and
nonperforming loans. When banks' share prices fall, their cost of equity increases, which could then
reduce the net return on lending. This may cause banks to become more conservative in their
lending in future and to raise the cost of lending. Internal calculations have shown that a decline
of around 10% in a bank's share price reduces corporate lending by around 0.5 percentage point.
Allow me, however, to comment on the sometimes severe criticism, especially from Germany,
that we face: the German banking sector is one of the largest in the euro area but at the same
time it's the least efficient. German banks have a cost-income ratio of 73%, which is much higher
than that of the rest of the euro area. And while other countries have cut the number of banks by
almost a quarter following the financial and economic crisis in order to reduce overcapacity, the
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corresponding figure for Germany was only 10%.
Traditional business models under review
The current low interest rate environment has not just revealed weaknesses among banks, it has
also called into question the traditional business models of insurance companies and pension
funds.
For many insurers in Germany, guaranteed returns have become an issue. In the current market
environment, it is becoming increasingly difficult to achieve the guaranteed interest rates of 4%
that were commonplace in contracts concluded in the mid-1990s. The German ministry of
finance has reduced the guaranteed interest rate for the current year from 1.25% to 0.9%. Many
insurance companies are now increasingly turning to unit-linked products.
In addition, new regulatory requirements are increasing the demand for safe assets. German
government bonds alone are yielding negative returns on maturities of up to seven years.
Against this backdrop, discussions are under way as to what can be done to counter this
shortage of safe assets. One suggestion is that market participants create a new kind of safe
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asset, known as European Safe Bonds (ESBies) , consisting of the senior tranche of a portfolio
of existing bonds from different euro area countries. The advantage here would be that no joint
liability would exist, as is the case in other proposals of this kind.
From a purely academic perspective, this is certainly an interesting idea. But it would be difficult
to counter the public's assumption that this would be a surreptitious mutualisation of sovereign
debt. The political desire to introduce ESBies in the near future is likely to be very limited.
I therefore don't see this proposal as being part of the operational agenda but rather as a subject
for long-term study.
Outlook
Let me conclude.
Weakening global growth and a generally lower natural interest rate are demanding very low,
sometimes negative, market rates so that investment and consumption become more attractive.
In the medium term we are thereby aiming to get inflation back to a level in line with our mandate
to ensure price stability of below, but close to, 2%.
Without our measures, the euro area economy would probably have slipped back into recession,
with the risk of fully fledged deflation. We had to act and have prevented things from getting
worse. Our measures have proved effective.
Our mandate is clear. It says that in the medium term we have to achieve an inflation rate of
below, but close to, 2%. This is the only goal that our unconventional measures are also bound
by. And price stability is an exclusively internal objective - the ECB does not pursue an exchange
rate policy.
Nevertheless, the longer it takes to achieve this goal, the greater the risk that the side effects of
our measures become stronger, especially of the negative rates. While we are doing what we
can to keep the side effects to a minimum, the financial industry must play its part and adapt as
far as possible.
The recovery has started. However, for it to be sustainable, we must first and foremost address
the causes of this global low interest rate environment. But monetary policy cannot manage this
on its own - not least because our measures are not intended to become a permanent feature of
the system.
The economic recovery cannot be sustained by monetary policy alone; it also needs support
from politicians. The main objective is to bring about a turnaround in global growth. This involves
stepping up fiscal policy measures where there is scope and need. We also require reforms that
increase productivity.
But even these political measures won't be effective if the virus of isolationism is rife. Because
the plague of protectionism only creates losers.
1
Eucken, W. (1990), "Grundsätze der Wirtschaftspolitik", 6th edition, J.C.B. Mohr (Paul Siebeck), Tübingen, p. 257.
2
See Rostagno, M., Bindseil, U., Kamps, A., Lemke, W., Sugo, T. and Vlassopoulos T., (2016), "Breaking through
the zero line: the ECB's negative interest rate policy", Brookings Institution, Washington DC, 6 June. The
presentation is available on the website of the Brookings Institution.
3
Borio, C., Gambacorta, L., Hofmann, B., (2015) "The influence of monetary policy on bank profitability", BIS
Working Paper October.
4
Mersch, Y. (2016), "Low interest rate environment - an economic, legal and social analysis", speech at the
University of Applied Sciences of the Deutsche Bundesbank, Hachenburg, 27 October.
5
Brunnermeier, M., Langfield, S., Pagano, M., Reis, R., Van Nieuwerburgh, S., Vayanos, D., (2016), "ESBies:
Safety in Tranches", ESRB Working Paper Series, No 21, September.