Mário Centeno: Policy mix of the future - the role of monetary, fiscal
and macroprudential policies
Keynote intervention by Mr Mário Centeno, Governor of the Banco de Portugal, at
the international conference "Future of Central Banking" organised by the Bank
of Lithuania and the Bank for International Settlements on the occasion of the
centenary of the Bank of Lithuania, Vilnius, 29 September 2022.
* * *
Good morning.
Let me start by explaining why I consider that the coordination between monetary and
fiscal policy is fundamental for the European Union to overtake the challenges of the
current uncertain economic context. Afterwards, I will also address the role of
macroprudencial policy.
Monetary policy gathered credibility over the past 40 years centred on the
independence of central banks and on a strong commitment to price stability.
The monetary dominance paradigm is a cornerstone of the institutional framework that
supports this credibility. And it plays an important role in the current high inflation setting.
Monetary policy must act to ensure that inflation expectations remain anchored,
whereas fiscal policy must be bound to public debt sustainability. However, as claimed
by central bankers over the last decades, the recent pandemic experience has shown
how monetary and fiscal policies can coordinate in many circumstances, and mutually
reinforce each other.
Notice that the low inflation, low interest rate environment that prevailed for over a
decade, favoured strategic complementarities between monetary and fiscal policy
towards macroeconomic stabilisation. In that environment, fiscal policy faced a less
steep trade-off between public debt sustainability and stimulating demand.
However, the pandemic legacy adds importance to debt sustainability. At the end of
2021, the euro area debt ratio was still 12 pp above the 2019 level.
Currently, as we move away from the zero-interest rate environment, rising debt
servicing costs are becoming again a concern, in particular for high-debt countries. In
the high inflation scenario, the trade-off between debt sustainability and macroeconomic
stabilisation is stronger, especially as inflation outcomes are mainly driven by supply
factors. Monetary policy is more effective when inflation is demand driven; fiscal policy
has the tools to address specific supply shocks as we face today.
Monetary policy also faces a challenging choice between a more gradual increase of
the policy rate, which takes into account the high uncertainty and its effects on the real
economy, and a stronger response that tames the risks of inflation remaining noticeably
above the objective for a protracted period.
A faster than warranted increase in policy rates may backslash in two ways. First, it
may dampen investment in a period in which we need it so badly to restore supply
chains and redesign globalization. Second, it may imply a backtrack in policy direction if
at end we did not need such a strong action to cope with medium term inflation
expectations, that I do not see de-anchored, as we speak.
My first principle for good economic policy of any sort is to act at the margin. The
second principle would be to be predictable and signal the way to go, so that economic
agents can adapt. And that is what monetary policy is all about: send price signals so
that firms and households can adapt their medium term expectations.
There is a lag involved. I would say "mind the lag".
In any case, as monetary policy normalises, higher interest rates are going to put
pressure on debt service costs, diminishing the fiscal policy room to adapt its
macroeconomic stabilisation stance.
Indeed, maintaining sustainable public finances is of utmost importance. The ongoing
normalisation of monetary policy cannot - will not - be constrained by fiscal space
considerations.
Fiscal policies must act primarily as countercyclical policies; buffers must be
accumulated in good times to ensure enough fiscal space in downturns. The EU
institutional framework favours countercyclical fiscal policies, not without challenges,
one must recognize.
However, the notion of fiscal space has changed under the current inflationary context.
On one hand, tax revenues are increasing fast in the short term, but the underlying
elasticities may no longer hold. On the other hand, the impact of inflation on the
expenditure will be lagged, including that stemming from the rise in interest rates. Thus,
there is a serious risk - or should I say, temptation - of overestimating fiscal space!
One that should not be neglected.
An effective interaction between fiscal and monetary policies also requires that fiscal
policy does not feed the inflationary process. Thus, any form of fiscal support should be
timely, temporary and targeted towards the most affected and vulnerable. And it
requires monetary policy not to impede the efforts of reconstruction of supply side
bottlenecks that resulted from the COVID and now this unwarranted war that develops
so close to you, which is to say in Europe.
Only in this way could we avoid the blame game of not long ago. Each side of the policy
spectrum claiming that the other side was eroding its room of manoeuvre.
The reform of EU fiscal rules and the enactment of the Budgetary Instrument for
Convergence and Competitiveness, approved in December 2019 as the embryo of an
Euro Area common fiscal capacity, could be the next steps forward to avoid these
constraints. They will reduce the risks of fragmentation, alleviating the pressure on
monetary policy, and moving towards a sounder interaction between policies.
It is always important to recall that the first time the euro support among Europeans
increased in the context of a crisis was in 2020. And this was no coincidence, it was a
clear understanding by our fellow citizens that for the first time ever in a crisis we were
acting as a Union. A Union with a purpose, a Union in which people could understand
the continuity across policies, both across each country and the EU, but also across the
different economic policy domains.
And that includes macroprudential policy.
Because monetary policy effectiveness also depends on an increasingly important role
of macroprudential policy.
The scope for interaction between these policies is large, as they share common
transmission mechanisms and can affect each other's objectives. The ECB's review of
the monetary policy strategy recognized that financial stability is a precondition for price
stability.
Macroprudential policy should be the first line of defence against financial stability risks,
notably in a monetary union where financial cycles are not fully synchronized.
Monetary policy is too "blunt" to deal with financial stability effectively.
The relevance of the interactions between monetary and macroprudential policies
cannot be played down. Monetary policy decisions affect the credit granted to the
economy and, therefore, can spur "side effects" - positive or negative - on financial
stability. On the other side, macroprudential policies, while containing financial stability
risks, may reduce the length and the magnitude of economic expansions by inhibiting
credit to finance productive economic activities.
The arguments for using monetary policy to explicitly and automatically deal with the
build-up of risks are weak. Leaning against the wind may not be desirable as a general
principle, even if keeping flexibility may be warranted to deal with specific situations. If
monetary policy is used in a systematic way, it could lead to a general loss of its
effectiveness and credibility.
However, monetary policy has played a crucial role in supporting financial stability in
several critical occasions.
Since the great financial crisis, central banks have increasingly recognised the
importance of providing liquidity and making sure that the transmission mechanism
operates properly.
More recently, the introduction of the ECB's Transmission Protection Instrument
provides an important backstop against expectation-driven self-fulfilling debt crises. It
allows for a clearer separation between market stabilisation and policy stance goals. It
broadens monetary policy space and enhances the efficiency of stance-related policy
actions. Again, the Transmission-Protection Instrument does not dispense the adoption
by Member States of the sound and credible fiscal policies.
Today's highly uncertain environment requires also agile policymaking; policies that
adapt rapidly to changing circumstances. However, the current inflationary context is
more challenging in this respect.
We should be aware of our mandates and acknowledge each other's responsibilities
and limitations. Within the specific mandates and without prejudice to independence,
there are strategic complementarities between the actions of fiscal authorities,
supervisors and central banks that can and should be explored under the right
conditions. Let me throw a challenge: Finance ministers and central bankers must
come together - physically - to communicate at once how we see each other achieving
more efficiently our necessarily common objectives. We will not hesitate one single
moment in order to achieve those; it is the price, the trade-offs, that we have to face
that must be discussed and minimized. Follow upon the legacy of the founding fathers
of the European project, it is crucial that we - policy makers - keep on building bridges.
As Amanda Gorman so nicely put it for the US, we are not striving to form a Union that
is perfect, we are striving to forge a Union with a purpose.
Thank you.