Benoît Coeuré: Monetary policy in a low-growth environment
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank, at
the 4th Frankfurt Conference on Financial Market Policy, organised by the Sustainable
Architecture for Finance in Europe Policy Centre, Goethe University, Frankfurt am Main, 28
October 2016.
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Since the onset of the crisis, the ECB has introduced a wide range of unconventional measures
in order to meet its inflation objective, including negative deposit facility rates, targeted long term
refinancing operations, and asset purchases. These measures were - and remain - necessary,
and have been effective. But in the public debate, there is an increasing focus on the potential
negative side effects of these measures and the rationale behind their deployment. This triggers
two questions: why did we launch unconventional monetary policy in the first place? And how can
we mitigate the potential risk of negative spillovers from monetary policy over the medium term?
The answer to the first question is clear - these measures have been taken to react to the large
negative shock caused by the global financial crisis, which has exacerbated a number of
structural factors that have been driving down real interest rates even before the crisis. The
unconventional measures are a reaction to the challenge of low global interest rates, not
their cause.
In my remarks today I will set out the challenges for monetary policy caused by structural factors
such as low interest rates and low productivity growth. Understanding the structural nature of
these challenges is key to answering my second question on mitigating potential spillover risks
from monetary policy in the future.
The impact of low productivity growth on monetary policy
To understand the structural challenges for monetary policy, it is useful to consider two
interlinked concepts for the setting of monetary policy - potential output and equilibrium interest
rates. Understanding the interplay between these two concepts is at the heart of the current
policy settings of the European Central Bank. How they evolve will determine the future path for
inflation and at what stage monetary policy can eventually be normalised.
Potential output represents the level of activity where capital and labour are sustainably used.
Equilibrium nominal rates are the level of nominal interest rates where there is neither upward
nor downward pressure on activity, and are composed of two parts: the real equilibrium rate and
inflation expectations. Actual levels of activity above potential put upward pressure on inflation
and levels below potential put downward pressure. In similar fashion, setting actual interest rates
below equilibrium rates stimulates economic activity, whereas setting interest rates above
equilibrium restrains activity.
Over recent years, economic activity in the euro area has been below potential - in other words
there has been a negative output gap - which has put downward pressure on inflation. The
classic textbook prescription is simple: loosen monetary policy to drive interest rates below
equilibrium, stimulating output to bring it back to potential and generate inflationary pressures to
achieve the inflation objective. In general terms, the ECB's monetary policy since the crisis fits
that textbook prescription.
But the finer details also matter. Simple models in textbooks assume that the growth of potential
output and the rate of equilibrium interest rates are fixed and immutable. In reality, productivity
growth has slowed in the euro area and other advanced economies. Combined with
unfavourable demographics, the slowdown in productivity has depressed potential output growth
and lowered equilibrium interest rates. The productivity slowdown has been particularly
pronounced in the euro area, where both total factor productivity and capital per employed person
have markedly slowed down.
These changes matter for the conduct of monetary policy, and they create a dilemma. The
slowdown in growth below potential has increased the need for macroeconomic stabilisation. At
the same time, the overhang of public and private debt and their interaction through the
banksovereign nexus impairs the use of fiscal policy and places a greater burden on monetary policy
to carry out that stabilisation. Yet the fall in equilibrium rates reduces the margin of operation for
traditional monetary policy instruments to stimulate the economy. Let me address these three
elements in turn.
The greater need for macroeconomic stabilisation
Shocks constantly hit economies, driving activity away from potential and inflation away from the
central bank's objective. Recent examples include the global financial crisis and large
fluctuations in oil prices. In principle, these deviations from potential output can be managed by
appropriate macroeconomic stabilisation. But cyclical deviations can have more lasting effects
on potential output through a process termed hysteresis.
For example, following a prolonged period of output below potential, the public may become
pessimistic about future growth and income prospects and consequently reduce consumption
and investment. In the short term, lower consumption and investment worsen the negative output
gap and are deflationary. The lower investment also reduces longer-term capacity and hence
future potential output. In a similar fashion, there is a risk of hysteresis. This means that people
made unemployed due to the cyclical downturn may remain out of employment for too long,
losing valuable human capital and finally becoming structurally unemployed, a tragedy for them
and their families, and a loss for society.
There is some evidence that the prolonged period of negative output gap in the euro area since
the crisis has weighted on potential. Potential growth is estimated to have fallen from 1.6% a year
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over the period 2000-07 to 0.7% over the first five years of the crisis. Skill mismatch has
increased in a number of countries, in part arising from the shift in sectoral composition as the
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construction sector shrunk rapidly. The high rates of youth unemployment are also likely to
result in labour market "scarring".
The financial crisis and the bank-based nature of finance in the euro area amplified the slowdown
in potential growth. The transmission of monetary policy in the euro area has been impaired by
fragilities in the banking system, compounded by the overhang of public debt, on which I will
shortly say more. Loss of access to finance can have a marked impact on business
performance and in aggregate lower potential output.
To put some perspective on the problem, let me highlight recent research carried out for the
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ECB looking into the impact of loss of finance on firm performance in the euro area. The
research looks at thousands of loan applications made by small and medium-sized enterprises
to a major German bank between 2009 and 2012. In particular, it focuses on firms that are
around the cut-off line for loan acceptance. These firms are in general very similar in terms of
balance sheet and profitability metrics, but some lie slightly above the line and some lie slightly
below.
The study maps the outcomes for those firms in the year following the loan rejection. On
average, a rejection leads to a 9% fall in assets, and lower investment and employment. The
effects are amplified in firms with low liquidity, with such firms seeing a 5.6% fall in investment
and a 7.2% fall in employment. Yet these are not unprofitable or inefficient firms - the average
return on assets for firms just below the cut-off line is a little over 14%.
The long-term risk from the prolonged period of sluggish growth also extends beyond real activity
into prices. A key part of our monetary policy is to anchor inflation expectations around our -
price stability aim of a rate of below, but close to two percent over the medium term. Although our
objective is forward looking, there is a risk that continued undershooting of our inflation aim will
cause households and firms to revise down their inflation expectations. And lower inflation
expectations directly lower the equilibrium nominal interest rate, requiring a lower interest rate to
create monetary stimulus. Thanks to our measures, inflation expectations have remained
anchored. According to the ECB's latest survey of professional forecasters, expected inflation at
a five-year horizon is 1.8%. But market-based expectations have been lower and more sensitive
to current levels of inflation, and without our measures, the risk of a de-anchoring would have
been very serious.
The increased burden on monetary policy
Taken together, a long period of growth below potential requires robust policy action to prevent
the low growth from becoming entrenched into the long run. But at the same time, falling potential
growth also increases the burden on monetary policy to carry out that macroeconomic
stabilisation.
The policy mix in the euro area is already heavily tilted towards monetary policy given the
decentralised nature of fiscal policy by 19 national governments and the limited success of
European fiscal rules in creating incentives to build up national fiscal space. The available fiscal
space in most euro area countries is in addition constrained by the overhang of public debt
inherited from the crisis. Lower potential growth and weaker inflation inhibit the reduction of public
debt ratios by acting on both sides of the fraction. Higher expenditure arising from higher
structural unemployment and lower tax revenues from weaker inflation restrict the ability of
governments to save, i.e. reduce the numerator. And low inflation increases the real savings
required to serve a given level of nominal debt. Similarly, weaker potential growth lessens the
ability to increase the denominator and grow out of the overhang.
Since the crisis, the overhang of public debt has not just reduced the ability of fiscal policy to
share the burden of macroeconomic stabilisation with monetary policy, but it has also impaired
the transmission of monetary policy through the sovereign-bank nexus.
Recent research by the ECB shows that during the sovereign crisis, banks in stressed countries
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increased their holdings of domestic sovereigns. This was particularly marked for publicly
owned banks and recently bailed-out banks. As the price of stressed sovereign bonds fell, these
banks were forced to deleverage, reducing their lending. This drop in lending was not just
confined to the domestic market - foreign subsidiaries of banks with head offices in stressed
countries also reduced lending. The notion that sovereign bond purchases by domestic banks
acts as a useful stabilising mechanism in the face of financial stress therefore needs
qualification.
The reduced margin of operation for monetary policy
As I have just mentioned, falling growth rates had increased the need for macroeconomic
stabilisation, and put greater burden on monetary policy to carry out that stabilisation. But it has
also affected the capacity of monetary policy to stimulate the economy. That is because the
longrun growth in output is an important determining factor of equilibrium interest rates, which have
been falling in major advanced economies for the best part of the past three decades.
As I noted above, in order to generate inflationary pressure in the economy, central banks have to
set interest rates below equilibrium. As equilibrium interest rates have declined, so has the
interest rate that is stimulatory. Estimating equilibrium rates is tricky, and estimates are subject
to bands of uncertainty. But a range of estimates puts the euro area real equilibrium rate, which
is to say the equilibrium rate minus inflation expectations, at close to zero, with some measures
even negative.
To provide the required monetary accommodation to bring inflation back to our objective, the
ECB has needed to bring the main refinancing rate to zero, and our deposit facility rate has been
negative since 2014. These low and negative rates are a direct consequence of the decline in the
equilibrium rate. If that rate were higher, so would our interest rate settings. Failing to follow the
move lower in the equilibrium rate would have created the risk of remaining trapped in a low
growth, low inflation equilibrium or even of falling in a deflationary spiral.
But there are limits to how low interest rates can go. First of all there is the physical lower bound,
where households and businesses disintermediate the banking sector and hold their money in
cash. Experience of other central banks shows that the physical lower bound is below where we
currently have our deposit facility rate. But there may well exist an economic lower bound at
which the negative impact on monetary policy transmission through banks outweighs the positive
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benefits of low rates for economic activity. Low interest rates have implications for bank
profitability in both the short and long term and can weigh on credit provision and financial
stability.
Such negative effects have not materialised so far, partly because lower rates have initially
generated capital gains on banks' fixed-income portfolios and lowered banks' funding costs, and
partly thanks to the overall positive impact of low rates on the volume and riskiness of bank
loans. But over time, falling rates will squeeze bank interest margins.
In the longer run, there are also risks to financial stability if low interest rates result in asset price
bubbles, which are vulnerable to sharp reverses once interest rates rise. Similarly, if banks
"search for yield" by increasing lending to lower quality borrowers or if they roll over non
profitable, "zombie" loans to ailing companies, there may well be a higher aggregate default risk.
ECB staff estimates suggest that recent monetary policy actions in the euro area have so far
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been net positive for bank profitability, relative to a scenario of no policy action, and we don't see
today asset price bubbles which would threaten the euro area's financial stability. But if rates are
low for too long, the negative effects may well dominate and impair the effectiveness of our
measures.
Of course, low interest rates are not the only factor affecting bank profitability in the euro area.
Europe as a whole is overbanked, and a number of jurisdictions have suffered from low
profitability and high cost-to-income ratios for several years. With interest rates likely to remain
low for the foreseeable future, even once monetary policy normalises, banks will have to revisit
their business models to ensure continued profitability over the medium term.
The monetary policy reaction
Faced with activity below potential and inflation below its objective, the ECB has sustained
accommodative monetary policy since the onset of the crisis. We have responded to the fall in
equilibrium rates and the negative output gap by cutting our main refinancing rate to zero and our
deposit rate into negative territory. Our targeted long-term refinancing operations have
encouraged lending by banks and helped to mend the transmission mechanism.
More recently, our asset purchase programme (APP) has sought to influence a broader range of
interest rates. This recognises that there is in fact not just one equilibrium rate, but a
constellation of rates across a range of maturities and credit conditions that are important for the
borrowing decisions of firms and households.
It is clear that the accommodative monetary stance is having the desired effect in the euro area.
GDP growth continues, albeit still at a sluggish pace. According to the European Commission's
most recent estimates, the negative output gap has more than halved since 2014, from -2.5% to
a projected -1.1% this year. The euro area unemployment rate fell from 11.2% at the start of
2015 to 10.1% now. Headline HICP inflation has risen by a percentage point over the same
period, although mostly through the removal of energy price base effects. Credit standards have
been loosening for firms and households, loan demand is increasing and banks are using the
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additional liquidity from the APP to grant more loans.
There is, so far, little evidence of negative effects from our unconventional measures. Bank
deposits continue to grow, and there is little sign of a disproportionate increase in holdings of
cash, so the low interest rates are not causing disintermediation. Similarly, there is little sign of
excessive increases in real estate prices across the euro area as a whole, although some local
markets have begun to see some stronger increases.
Taken together, the ECB's current policy settings are appropriate and are clearly providing the
support required to sustain the recovery. In providing that support, we are minimising the risk that
the sluggish growth becomes entrenched as enduring stagnation and that inflation becomes
deanchored. Monetary support for the recovery will continue until inflation is sustainably adjusting to
our objective.
Ensuring sustainable policies for the future
But there is a risk that prolonged use of unconventional measures brings about greater risks.
Absent structural changes to potential growth and equilibrium interest rates, so-called
unconventional measures will become conventional measures in the euro area.
Because monetary policy has shouldered the lion's share of the burden of post-crisis
stabilisation, the debate has naturally centred around what the ECB should do. However,
structural problems require structural solutions and other actors need to shoulder some of the
burden. The public debate needs a renewed, wider focus.
In particular, fiscal policy has to shoulder a greater share of the burden of macroeconomic
stabilisation by providing better support to investment and by achieving a growth friendlier
composition. Equilibrium interest rates have to rise from their current low levels through
structural reforms improving the efficiency of our economies.
Other actions are needed to ensure euro area resilience over the medium term, and may take
some time to have their effects. This includes steps to complete banking union, complement it
with a capital market union and address in a credible way the bank-sovereign nexus. This may
also include steps to create a common fiscal capacity, backed by credible rules for national
budgets and under appropriate democratic scrutiny.
As our political fabric is under severe strains, these are not low hanging fruits. But postponing the
necessary reforms is not a valid option anymore. Procrastination and forbearance have not
served the euro area well. Our financial system is a case in point. If our banks had been cleaned
up and strengthened early after the crisis, our growth path would today be higher.
Building a more resilient euro area economy through better rules and structural and financial
sector reforms will protect the potency of monetary policy to perform its stabilising role in the
presence of structurally low equilibrium interest rates. But the benefits extend beyond short-term
macroeconomic stabilisation. Higher potential output recreates fiscal space for governments and
shifts equilibrium interest rates upwards. If the reform path is credible, part of these benefits can
materialise today. Higher equilibrium rates, and a smaller share of the stabilisation burden, will
reduce the need for monetary policy in the future to use the full range of its unconventional
measures. But by far the best dividend from these reforms will be to improve the welfare of euro
area citizens and their trust that Europe can make their lives better. This in itself is a matter of
urgency.
Anderton, R. et al. (2014), "Potential output from a euro area perspective", ECB Occasional Paper Series No.
156.
2
Anderton, R. et al., ibid.
3
Berg, T., (2016), "Got rejected? Real effects of not getting a loan", ECB Working Paper Series No. 1960.
4
Altavilla, C., Pagano, M. and S. Simonelli, (2016), "Bank exposures and sovereign stress transmission", ECB
Working Paper Series No. 1969.
5
Constâncio, V., (2016), "The challenge of low real interest rates for monetary policy", Lecture by Vítor Constâncio,
Vice-President of the ECB, Macroeconomics Symposium at Utrecht School of Economics, 15 June 2016.
6
Coeuré, B., (2016), "Assessing the implications of negative interest rates", Speech at the Yale Financial Crisis
Forum, Yale School of Management, New Haven, 28 July 2016.
7
See Rostagno, M. et al., (2016), "Breaking through the zero line: the ECB's negative interest rate policy",
Brookings Institution, Washington DC, 6 June 2016. Presentation available on the Brookings Institution website.
8
ECB (2016), "Euro area bank lending survey", Third quarter 2016, European Central Bank, October.