Peter Praet: Monetary policy at crisis times
Lecture by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the International Center for Monetary and Banking Studies, Geneva, 20 February 2012.
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Introduction
It is a real pleasure for me to share my thoughts before such a distinguished gathering here
Centre International d'Etudes Monétaires et Bancaires.
at the
Advanced economies have all lately witnessed a "sequence" of crises which had a
considerable impact on the state of the financial system and the global economy at large. For
the euro area, the last few years have been especially turbulent. The sovereign debt situation
in some euro area Member States is at the heart of concerns about financial and economic
stability in the euro area.
The sovereign debt crisis pointed to an imperfect implementation of economic - but clearly
not monetary - governance in the euro area. As a currency, the euro has been a success. At
the same time, it has become clear that continued success hinges crucially on overall sound
economic and financial policies in the euro area Member States.
With this in mind, I will structure my remarks under two main headings. First, I would like to
briefly review some key elements of the institutional framework governing monetary and
fiscal policy in European Monetary Union. Thereby, I will point to the root causes of the
sovereign debt crisis but also to the considerable progress made more recently in putting
fiscal governance on more solid footing.
Second, I will more closely review the role of monetary policy in the mist of what turned out to
be the worst crisis since the Great Depression, arguing that the ECB has boldly reacted to it
with a series of both standard as well as non standard measures, in full preservation of its
medium-term oriented mandate of price-stability.
The crisis, institutional framework and policy responses
The crisis has reinforced the insight that monetary union needs to be based on
fundamentally solid institutional anchoring. So let me take the occasion to revisit some of the
institutional rationale behind the construction of European Monetary Union.
One main anchor of this framework is an independent monetary authority primarily entrusted
to deliver price stability. However - as we have witnessed - appropriate monetary policy
strategy and actions by the central bank are not necessarily sufficient to maintain
macroeconomic stability. Stability also requires appropriate fiscal policy, namely a credible
commitment by the government to ensure that any temporary increases in deficit will be
eventually offset by corrective measures.1 Hence, the second anchor of a monetary union is
governments that are committed to maintaining solid public finances.
The institutional framework governing EMU reflects these insights. On the central bank side,
the maintenance of price stability over the medium-term is the most important contribution
that monetary policy can make to sustainable growth, employment, and social cohesion. On
the fiscal side, the institutional framework reflects our long-standing experience that sound
and sustainable fiscal policies are in turn fundamental to fostering longer-term sustainable
economic growth.
Following these principles, monetary and fiscal policies are mutually re-enforcing. Solid fiscal
policy is conducive to a macroeconomic environment that facilitates the task of a
stability-oriented central bank. At the same time, credible monetary policy contributes to a
smooth conduct of fiscal policies by guaranteeing stable inflation expectations and low
inflation risk premia, which is in turn beneficial for the level and volatility of long-term
government bond yields and therewith sovereign financing costs.
For both policies to successfully do their jobs, a clear assignment of their objectives and
reign of action is warranted in a monetary union. While fiscal policy is ideally suited to absorb
country-specific shocks, monetary policy safeguards price stability in the monetary union as
a whole.
This is what the "founding fathers" of EMU had in mind when they assigned the responsibility
for monetary policy to the Eurosystem endowing it with the primary objective of safeguarding
price stability across the euro area as a whole. Such assignment was flanked by the
provision of a high degree of independence to the ECB - institutional, financial as well as
functional.
As a core component of its monetary policy strategy, the ECB has from its start announced a
quantitative definition of price stability to be maintained over the medium term. In 2003 the
Governing Council has clarified that it aims to keep HICP inflation below, but close to,
2% over the medium term to achieve its objective. This decision was intended to serve also
as a hedge against the risk of deflation occurring.
As another component of its strategy, the ECB has announced a clear framework for
assessing the risks to price stability. Within its "two-pillar" strategy, the short-to-medium term
indications on inflationary developments stemming from its economic analysis are
"cross-checked" with the signals extracted from the monetary analysis.
More than thirteen years after its inception, we can state that the Eurosystem and its
monetary policy have delivered upon their responsibilities. The policy measures by the ECB
Governing Council have resulted in an inflation rate which is in line with our quantitative
definition of price stability.
On the fiscal side, the picture has been less positive, though. The fiscal stimulus measures in
response to the financial crisis, large-scale government support programmes for ailing
domestic banking systems, the working of automatic stabilizers and eroding tax bases in the
face of weakening growth have put government budgets in the euro area countries under
intense pressure. However, let me emphasise that for some euro area countries government
budgets had already suffered from lax fiscal policy before the crisis. Governments which
entered the crisis with significant fiscal imbalances exited the recession with the highest
deficit and debt-to-GDP ratios recorded in times of peace. The aggregate fiscal balance of
the euro area increased from a close-to-balanced budget in 2007 to a deficit of more than
6% of GDP in 2010, with a debt ratio rising from about 66% in 2007 to more than 85% in
2010 - and still increasing. This already drastic aggravation of public finances in the
aggregate masks much more extreme developments for some individual countries.
The sovereign debt crisis has shown that sound public finances are all the more important in
a monetary union where a large number of independent fiscal policy-makers share the
benefits of a single currency, gaining access to a large pool of savings and being immunized
against exchange-rate risk.
Originally, it was expected that financial market pressures as well as Treaty obligations
would provide strong disciplining devices for Member States to maintain sound public
finances and to engage in structural reforms.
Firstly, financial markets were expected to discriminate between sovereign borrowers,
leading to differentiated long-term bond yields across issuers with differing degrees of fiscal
soundness.2
However, as we have seen during several years before the crisis, markets did not come up
with differentiated pricing, but rather with a fairly complacent pricing of risk across the board.
In the wake of the financial crisis, these - one might say, "falsely comforting" - steady states
have abruptly turned around. On the one hand, the government bond yield increases that we
saw over the last years certainly contained episodes of overshooting, not fully reflecting
economic fundamentals. On the other hand, the re-pricing served as an important wake-up
call that strongly pushed for consolidation of public finances and urged policymakers to
re-think fiscal governance in Europe.
Secondly, euro area countries were bound by the "no-bail-out" rule and the Stability and
Growth Pact. They were supposed to implement the necessary structural and fiscal policies
to ensure sound and sustainable economic positions within EMU.
However, when we look backwards, the joint responsibility for effective surveillance too often
took the form of "peer support" instead of "peer pressure". It became also clear - and the
ECB had warned several times - that the intended "more intelligent" interpretation of the
SGP ultimately failed to produce the desired increase of ownership, which can only be
gained if all agents internalise the rationale behind sound, simple and easily monitorable
rules. The role of such rules was, and remains, to provide credible incentives for sound fiscal
and macroeconomic policies in a monetary union.
In this sense, it is encouraging to see that important steps have recently been taken. One
step was the governance reform package (the so-called "six pack"), which came into force in
December 2011. It strengthens both the preventive and the corrective arm of the Stability
and Growth Pact and establishes minimum requirements for national budgetary frameworks.
It was also important that the Heads of State or Government have further agreed on a new
"fiscal compact" with a view to achieving a more effective disciplining of fiscal policies. Major
elements of the fiscal compact are the strengthening of the role of the balanced budget rule
and a further tightening of the excessive deficit procedure. It is of utmost importance, that the
rules are now fully implemented in the spirit of this agreement. All these measures aim to
ensure that individual countries live up to their responsibilities to bring their public finances in
order.
In addition to imbalances in public finances, the crisis has also brought to the fore two
additional key issues: first, cross-country differences in competitiveness and economic
growth; and second, the importance of interlinkages between banks and sovereigns.
As regards the first issue, in some euro area countries - as I said before - the incentives to
engage in structural reforms have been obviously insufficient. For these member states it is
now all the more urgent to undertake structural reforms to regain competitiveness, thereby
strengthening growth prospects and job creation. This includes fostering competition in
product markets, particularly in services sectors, and the reduction of rigidities in labour
markets.
As regards the second issue, let me stress the importance of a more sound and resilient
financial system. In this respect, recent steps like the Basel III framework mean some good
progress in this direction. Nonetheless, further bold policy actions need to be taken. This
includes in particular the establishment of effective bank resolution schemes for systemically
important financial institutions and an improved supervisory framework with new
macro-prudential tools. The establishment of the European Systemic Risk Board and the
three European Supervisory Authorities are only first steps.
Finally, while the reforms of economic and financial governance that I mentioned are vital, it
is crucial that all these measures are complemented by a set of instruments that can directly
address financial market tensions. In other words, we need firewalls that tackle the threats to
financial stability and the risk of contagion - both between different sovereign debt markets,
but also between sovereign debt markets and other financial market segments. Therefore,
the setting up of the European Financial Stability Facility (EFSF) and its successor, the
European Stability Mechanism (ESM), represent important additions to the architecture of
EMU. In this context, I very much welcome the decision by the Heads of State or
Government to let the ESM enter into force already by July 2012, that is, one year earlier
than originally planned.
Monetary policy at the crisis: framework and recent measures
Having identified the need for reforming the framework for fiscal governance, the question
arises whether the institutional framework governing euro area monetary policy would also
benefit from some changes or finetunings. My view here is that our framework, with the
important institutional elements - that I have mentioned earlier - has in fact served us rather
well in conducting monetary policy both in turbulent and more tranquile times.
Nevertheless, recently some calls have been made on euro area monetary policy to adapt its
set of rules and to concede to the needs of other policy areas. Before I come back to this, let
me take a step back and look at the experience of other central banks, which
have - compared to our own relatively young institution - a longer history.
In the period after the Second World War in the United States, the Federal Reserve had to
completely accommodate the debt management policies of the Treasury. With inflationary
pressures rising, the conflict between the Federal Reserve and the Treasury escalated and
ended with the Fed-Treasury Accord of February 1951, which provided to the Federal
Reserve the independence to conduct its own interest rate policy. Central bank
independence has become a paradigm that is considered an essential element of any
stability-oriented monetary policy frameworks until today.3
Since the mid-sixties, the professional climate on monetary policy making was gradually
changing: monetary policy came to be more and more regarded as ancillary to fiscal policy or
was at least urged to coordinate closely with it. Loose policies during downturns failed to be
offset by tightened conditions over upswings. The result was a creeping public debt and
ratcheting inflation.
This example points to the risk of watering down established principles of monetary policy.
The important lesson to draw is that monetary policy makers need to be highly alert when
vested interests start to question the central bank's mandates, responsibilities and operating
frameworks. This holds in particular around crisis times.
Currently, one of the most pressing challenges is the idea that a central bank - and the ECB
in particular - should act as a "lender of last resort". The traditional definition of lender of last
resort typically refers to a reserve financial institution, most often the central bank of a
country, which directly intervenes in the market or via the extension of credit lines to avoid
bankruptcy of banks or other institutions deemed solvent. Provision of funding is therefore
direct, albeit temporary in nature.
Different is the notion that the central bank should act as the lender of last resort vis-à-vis
sovereigns, as it has recently been advocated. When calls are made for a central bank to
play the role of "lender of last resort" in government bond markets, such calls effectively
amount to the central bank being asked to directly fund illiquid sovereigns, either via direct
interventions on the primary market or by extending direct credit lines. Such activities are not
legally within the reach of the ECB, since the Treaty clearly imposes the prohibition of
monetary financing (Article 123 TFEU). There must not be any circumvention to this
prohibition. Again, this Treaty provision was not chosen arbitrarily. It is based on the
experiences in many countries over several decades, which taught us that a central bank
that bows to the needs of public finances cannot ultimately be successful towards delivering
upon its medium-term oriented price-stability objective. In particular, moral hazard could
weaken incentives for governments to pursue fiscal consolidation to safeguard or restore
fiscal sustainability. This will ultimately endanger price stability, and macroeconomic stability
more generally.
As a further complicating factor in the current crisis, the problems of public finances and
financial stability are closely intertwined. Here, we have to be especially vigilant to shield
monetary policy from attempts to engross it into inappropriate financial stability tasks; for
such attempts may turn out to be disguised aspirations to drag the well-established
paradigms of monetary dominance towards the realm of fiscal dominance.
Against this background, how should one interpret the ECB's interventions in euro area
public debt markets through its Securities Markets Program? As we explained at various
occasions, the SMP is purely founded on a monetary policy rationale. When we observed
that tension in some euro area sovereign debt markets were threatening a smooth
functioning of the transmission of our monetary policy, we set up the SMP in order to support
depth and liquidity in those market segments which had become dislocated. This was
essential so that we can optimally pursue our task of guaranteeing price stability in the euro
area.
Overall, it is essential that the clear demarcation lines provided in the Treaty are not violated
or shifted. This would constitute in fact a lasting damage and institutional regress to our
well-serving monetary policy framework, which would be intricate or even impossible to
reverse.
I will now, in the final part of my speech, conclude with a brief review of the main policy
decisions more recently adopted by the ECB in response to the crisis. I will not take you on a
full tour through our non-standard monetary policy measures that we started to take with the
onset of the financial crisis in 2007. I would rather like to focus on the more recent decisions,
addressing what we decided at the Governing Council meetings of last year's December and
last week.
An important part of the ECB's response to the crisis comes in the form of our "standard"
policy measures. In November 2011 the ECB cut its main policy rates by 25 basis points in
response to mounting downside risks to the growth outlook of the euro area and the global
economy, ultimately threatening price stability. These downside risks were also related to an
intensification of financial market tensions. Additional 25 basis points were cut in December,
since intensified financial market tensions continued to dampen economic activity in the euro
area. Since then, the rate on the main refinancing operations has been at the historically low
1%.
From the onset of the crisis, the ECB has also embarked in a series of non-standard
measures - as they are usually labelled - aimed at preserving the proper transmission of
monetary policy.
Among the measures announced in December, I recall that the Governing Council decided
upon two very long-term refinancing operations with a maturity of three years, the first of
which was already conducted last December. This duration is an innovation in ECB monetary
policy operations. It serves to give banks a longer horizon in their liquidity planning. It also
helps banks to a balanced and orderly deleveraging over the medium term, thereby avoiding
"fire-sales" of their assets and avoiding a downscaling of longer-term lending.
A second measure was to expand the set of available collateral. This allows banks to use
certain types of loans as collateral, which was unavailable for banks before. The broadening
of collateral standards will ensure that the liquidity provided under the three-year LTRO
operations will reach not only the large banks but also small and medium-sized institutes.
These tend to finance the small and medium-sized enterprises, which are the backbone of
the euro area economy.
The third measure was to reduce the required reserves ratio from 2% to 1%. This measure
releases liquidity of the banking sector of about 100 billion euro. In combination with other
measures, the reduction in the reserve requirements should likewise help revive money
market activity and support lending.
Again, the goal of all these measures is to maintain the appropriate credit supply to
households and firms, to ultimately guarantee price stability in line with our mandate.
At our recent meeting in February, the Governing Council decided to keep key interest rates
unchanged. According to our assessment, inflation is likely to stay above 2% for several
months to come, before declining to below 2%. Regarding economic activity, available
survey indicators confirm some tentative signs of a stabilisation at a low level around the turn
of the year, but the economic outlook remains subject to high uncertainty and downside risks.
For the temporary acceptance of additional credit claims as collateral, upon which the
Governing Council had decided last December, it approved specific national eligibility criteria
and risk control measures.4 This measure will facilitate a more uniform transmission of the
single monetary policy across the euro area.
Conclusion
Let me conclude. The sovereign debt crisis has brought to the spotlight the weakness of
economic governance in the euro area. Important steps forward have been taken for
improving fiscal governance and redressing the public finance situation in several member
countries. At the same time, macroeconomic imbalances across the euro area need to be
addressed by suitable policies geared towards fostering competitiveness and spurring
economic growth. In drawing the right lessons from this recent episode, the euro area has
the chance to emerge strengthened from this crisis.
As regards monetary policy, the ECB response to the challenges has been swift and
resolute. Besides the reduction in policy rates, the Eurosystem has implemented several
non-standard measures that ensure the proper working of monetary policy transmission and
the provision of liquidity to the euro area banking system. In particular with its most recent
measures since December last year, the Eurosystem has crucially helped maintain the credit
flow to the real economy.
At this stage it is essential to counteract any attempts that aim to burden monetary policy
with tasks that are beyond its mandate of maintaining price stability or violate the principles
enshrined by the Treaty. This is a key condition for monetary policy to remain an anchor of
stability in turbulent times.
I thank you for your attention.