Modesty in times of uncertainty
Monetary policy after the crisis
Business Economists' Annual Dinner (London, 29 November 2017)
Speech by Klaas Knot
Introduction
Good evening everyone. Thank you for inviting me here to share my thoughts on
monetary policy. We stand at an important turning point, 10 years after the
global financial crisis began to unfold. During the crisis, monetary policy stepped
in with unprecedented measures. At each new turn of the crisis, we as the
Eurosystem took action and designed new policy measures where necessary.
These measures proved successful. Now, a broad-based economic expansion is
taking hold across the euro area. As the economy is enjoying robust growth, it is
giving us the opportunity to take a step back from the crisis mode.
Against this background, tonight I want to elaborate on the following. The
current inflation outlook poses no threat to price stability. Despite
undershooting its inflation aim in the near-term, the ECB is thereby fulfilling its
mandate. This is thanks to a combination of monetary policy measures, including
the Asset Purchase Programme, which has achieved what could reasonably have
been expected. The slow inflation convergence towards our medium-term
objective is due to global supply factors largely outside the realm of central
banking.
In this situation, continued monetary expansion is not a free lunch.
Unconventional monetary policy is more intrusive than conventional monetary
policy. It creates deeper market distortions that can generate misallocation and
financial stability risks. As long as the standard economic relation between
domestic slack and inflation, the so-called Phillips curve, fails to assert itself,
adding ever more stimulus makes our policy increasingly procyclical, reinforcing
these risks.
I therefore want to argue for modesty in monetary policy-making. We need more
emphasis on the medium-term orientation of our inflation objective. Patience is
thereby of the essence. Absent deflation risk, a full phasing-out of net asset
purchases from September 2018 onwards is warranted. Our communication will
have to shift accordingly, from net asset purchases and incremental stimulus
towards reinvestment and preservation of broadly accommodative financing
conditions.
A quick look back
Let me begin by taking a quick look back. The euro area has endured some rough
times. In the aftermath of the global financial crisis, the euro area weathered a
sovereign debt crisis and a severe recession. These developments affected
financial market actors, households, firms and governments. In an attempt to
soften the impact of the crisis, the ECB took unprecedented monetary policy
measures. Liquidity was provided in full allotment, and for longer periods than
ever before. Interest rates were cut below zero, and several outright purchase
programmes were set up. An indicator developed by the Dutch central bank
shows that our actions were collectively equivalent to cutting short-term
interest rates to around -4%.1 Faced with severe challenges, the Eurosystem
responded forcefully.
Being here in London tonight, allow me to highlight one crucial moment 5 years
ago, when the functioning of sovereign debt markets in the euro area was
severely undermined in the presence of redenomination risk fears. On July 26,
2012, our President Mario Draghi gave his famous "Whatever it takes" speech.
Shortly after, the ECB announced its Outright Monetary Transactions (OMT)
programme. Markets calmed down, in the knowledge that the central bank
would intervene if needed. As they quickly realized the futility of speculating
against the central bank in its lender-of-last-resort capacity, no purchases
whatsoever were required under the OMT. This policy was successful on all
accounts.
Chart 1: Euro area inflation
Euro area inflation
Annual percent change
4
3
2
1
0
-1
12 13 14 15 16 17
HICP Core inflation (excl food & energy)
Stemming a speculative attack on the integrity of your currency is one thing,
controlling inflation is clearly a different ballgame. Whereas a central bank can
credibly promise to do "whatever it takes" in lender-of-last-resort capacity,
financial markets should not overestimate central banks' ability to fine-tune
inflation.
Since the acute crisis abated, euro area inflation has been low and rising only
slowly. As chart 1 illustrates, core inflation fluctuated slightly below 1% between
2014 and early 2017, and has yet to show more convincing signs of a sustained
uptick. It is good to realize that stubbornly low inflation is not just a European
phenomenon. Inflation in the US today, once corrected for imputed housing costs
and thereby made comparable to our HICP measure, is actually lower than in the
euro area, even though the economic and monetary policy cycles in the US are
several years ahead compared to the euro area.
The universal nature of subdued inflation is increasingly linked to favourable
supply-side developments such as technological advances and globalisation of
product, labour and capital markets. The resulting disinflationary factors are
global in nature and largely outside the realm of individual central banks. They
have altered domestic inflation processes and have thus complicated the life of
central bankers around the world.2
Chart 2: Euro area GDP growth
Euro area real GDP growth
Quarter-on-quarter percent change
1,0
0,8
0,6
0,4
0,2
0,0
-0,2
-0,4
-0,6
12 13 14 15 16 17
The inflation outlook
I would nonetheless argue that the current low inflation rates, despite falling
short of our medium-term objective, do not constitute a threat to price stability.
The current inflation outlook should be assessed against the background of a
robust expansion of the eurozone economy. As chart 2 illustrates, the euro area
is currently enjoying its fifth consecutive year of GDP growth. Since mid-2014
this growth can also be dubbed "reflationary", in the sense that quarterly growth
readings have consistently outpaced potential growth rates.
Against the backdrop of a reflating economy, the inflation outlook is consistent
with our aim of an inflation rate of below, but close to, 2% over the medium
term. It should be emphasized that from the ECB's early days onward, the
medium term has been defined as a flexible concept. It depends on the shocks
hitting the economy and the efficacy of the monetary policy transmission that
should bring inflation back on target. The global financial crisis was arguably
much deeper than the average shock foreseen at the euro's inception, and the
financial fragmentation it created within the euro area severely impeded
monetary transmission. In a context of such widespread financial imbalances,
the ECB's first chief economist, Otmar Issing, argued that "there is little sense in
continuing to pursue an inflation forecast for consumer prices over a horizon of
one to two years. In such circumstances it may instead be advisable to set
interest rates with a view to a time frame extending well beyond conventional
forecast horizons."3
Concerns have been voiced that a prolonged period of low inflation could lead to
a de-anchoring of inflation expectations. While the conceptual relevance of this
argument is beyond dispute, there are some challenging issues in
operationalising it in the monetary policy process. Market-based and survey-
based measures of inflation expectations exist, but they both come with a range
of caveats and have often provided conflicting signals as to whether inflation
expectations were anchored or not. Moreover, the mechanism by which inflation
expectations affect actual price- and wage-setting behaviour is far from
understood. I therefore sympathize with former Fed Governor Dan Tarullo, who
recently argued that "inflation expectations are bearing an awful lot of weight in
monetary policy these days, considering the range and depth of unanswered
questions about them".4
All in all, I am confident that our monetary policy measures will continue to work
their way through the transmission mechanism. Also at current low inflation
rates the ECB is fulfilling its price stability mandate and successfully protecting
the purchasing power of European citizens.
Current policy stance
So where does this assessment leave me in terms of the current monetary policy
stance? After all, the crisis is several years behind us, the economy is enjoying
solid expansion, price stability is not in jeopardy, yet many of our
unconventional monetary policy measures are still in place. Liquidity operations
are still conducted under fixed-rate full allotment, significant volumes of
Targeted Longer-Term Refinancing Operations are still outstanding, and the
deposit facility rate is still in negative territory. But the measure that has
attracted most controversy in the recent years is our Asset Purchase Programme
(APP). As you will be aware, the programme has just been extended until at least
September 2018, albeit at a reduced pace of 30bn a month. As stated in our
Introductory Statement, "The recalibration of our asset purchases reflects
growing confidence in the gradual convergence of inflation rates towards our
inflation aim."
Although at past occasions I have been sceptical about the APP's effectiveness
with respect to raising inflation, the APP has contributed to four important
achievements which I would like to recall here. First, the APP has further eased
financing conditions across the euro area up to the point where borrowing costs
are no longer an impediment to whatever spending decision. This also means
that since monetary policy constraints have become de facto non-binding, the
marginal benefits of further accommodation are negligible. Second, financial
fragmentation between euro area countries has been reduced and monetary
transmission has become much more homogeneous across Member States than
was the case during the crisis. Third, the APP has supported the strong economic
expansion I talked about earlier. Fourth, and perhaps most importantly, the tail
risk of a 1930s type deflationary spiral has been averted. In doing so, the
programme has achieved what could reasonably be expected from it.
With deflation risk clearly off the radar, the main rationale for employing the
APP has therefore ceased to exist. Fear of relapse owing to an alledgedly
premature discontinuation of net purchases seems rather overdone. The
programme has simply run its course. Continuing the programme for the sake of
fine-tuning inflation rates to precise values below, but close to, 2% suggests a
degree of control over the inflation process that is at least debatable.
Risks and side effects
At the same time, continued monetary expansion is not a free lunch.
Unconventional policy measures can have unconventional consequences that
even professional economists cannot always oversee. A prolonged period of low
interest rates, ample liquidity and prominent central bank intervention in
markets has given rise to potential misallocation of credit and wider resources
toward zombie firms.5 Risk premia are compressed to a point where they no
longer reflect the assets' inherent risk characteristics. The dynamics of
preventing financial markets to adequately price risks for an extended period of
time takes our economies into largely uncharted territory.
These financial stability risks also need to be considered when assessing our
monetary stance. While some would argue that prudential and not monetary
policies should address financial stability risks, I tend to agree with former Bank
of England deputy Governor Charles Bean that there are "important
qualifications to this somewhat Panglossian view of the ability to maintain both
price stability and financial stability by assigning monetary policy to the former
and macroprudential policy to the latter."6 After all, only monetary policy sets
"the universal price of leverage".7 Conversely, materialization of financial
stability risks can also become detrimental to price stability.
Procyclicality
In the current context, financial stability risks interact with the issue of
procyclicality. The failure of the traditional Phillips curve relation between the
business cycle and inflation to thus far assert itself makes monetary policy
increasingly procyclical. Economic growth in the euro area passed its cyclical
trough in the first quarter of 2013, while core inflation bottomed out early 2015.
Yet until at least September 2018 the APP will be adding stimulus. Not only in
terms of length, but also in terms of magnitude of the expansion, the economy is
in outstanding shape. With real GDP growth hitting levels above 2% year-on-
year, the monetary policy stance is increasingly out of sync with the business
cycle.
Chart 3: Euro area business cycle and monetary policy decisions
Euro area business cycle and monetary policy decisions
PMI number on y-axis, with 50 marking difference between business
cycle expansion and contraction
65
60
55
50
45
40
35
30
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Mean of PMI +/- 1⁄2 standard deviation
Composite Purchasing Managers' Index (PMI) index
Policy easing (rate decrease or APP decision/expansion)
Policy tightening (rate increase)
A simple historical comparison serves to illustrate this point. Chart 3 shows that
during previous upturns, that is when the euro area composite Purchasing
Managers' Index (PMI) stood at similar levels above its long-term mean, policy
was generally tightening instead of the current prolonged easing.8
Obviously, the main factor underlying this contrasting pattern is the weak and
elusive character of the traditional Phillips curve relationship between cyclical
conditions and inflation. Whether this is merely a temporary or a more
permanent phenomenon is a topic for ongoing debate. My colleague Mark
Carney, for example, has recently argued that "globalisation has been
accompanied by a weakening in the relationship between domestic slack and
domestic inflation, and by a corresponding strengthening between global forces
and domestic prices"9. Also in the euro area, the strong recovery of the labour
market has yet to translate into upward pressure on wages and prices.
Communication
Patience is therefore needed for our monetary stimulus to unfold. The reflating
economy will ultimately translate into increased pressure on wages and prices.
This may however take time. Central banks can only affect the price level with
"long and uncertain lags". Consequently they cannot be over-ambitious and try
to steer price developments in the short run, nor should they seek to precisely
define the horizon of their action.10 As we intend to reinvest maturing securities
for an extended period of time, financial conditions will likely remain
accommodative long after net asset purchases will have come to an end.
In view of the above, we have to adjust our communication. With a medium-term
focus in mind, we need to highlight patience and confidence in the measures that
we have already taken, while at the same time remaining realistic about what
our measures can and cannot achieve. We will need to cater for the possibility
that a sustained adjustment in the path of inflation (SAPI) can only be achieved
well after net asset purchases will have come to an end. Fortunately, our
monetary policy stance is more encompassing, and all our measures are geared
towards this objective. The focus in communication therefore needs to shift to
the other elements of our policy toolkit, such as forward guidance on key policy
rates, together with the ongoing stimulus provided by the stock of our asset
purchases.
Conclusion
Let me conclude. Our economy is in the midst of a strong cyclical upswing. Far-
reaching policy measures have contributed to cement growth, avert deflation
risk, and enhance the cohesion of the monetary union. Although raising inflation
towards our aim is taking longer than expected, current inflation rates are not a
threat to price stability. With actual growth exceeding potential and labour
market slack falling, inflationary pressures will eventually unfold. At the same
time, the longer the Phillips curve fails to assert itself, the more procyclical policy
might become, and the greater is the likelihood of financial stability risks
building up.
Patience and confidence should therefore replace suggestions of open-
endedness in our communication. Absent deflation risk, a full phasing-out of net
asset purchases from September 2018 onwards is warranted. Preservation of
existing stimulus will be more than sufficient to reach our inflation objective,
albeit at a medium term that may be further away than many of us are used to.
Let me then end with the more than relevant words of Augustus William Hare,
"True modesty does not consist in an ignorance of our merits, but in a due estimate
of them". Let us be modest and take a realistic look at what our measures can and
cannot achieve in our efforts to maintain price stability.
I thank you for your attention.