Vítor Constâncio: Challenges to monetary policy in 2012
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
26th International Conference on Interest Rates, Frankfurt am Main, 8 December 2011.
* * *
I would like to acknowledge the substantial contributions to the preparation of this speech by Marco Catenaro,
Philipp Hartmann, Oreste Tristani, Giovanni Vitale, and Guido Wolswijk.
Ladies and Gentlemen,
Since the introduction of the euro, our common currency, times have never been as
challenging as at present. Despite ongoing efforts by policy makers, the sovereign debt crisis
is still ongoing, putting growth and welfare of our citizens at risk. In this context the
Governing Council of the ECB met this morning and, as you know, decided to reduce the
monetary policy rate by 25 basis points and take a series of measures to improve liquidity
provision to the banking sector, thereby enhancing the operation of the credit channel.
I was asked to focus my address to you on challenges to monetary policy for next year,
2012. I decided to fulfil this request by covering three related areas. First, I will review the
current conjuncture and outlook for 2012, as the Governing Council sees it at present. I will
also take the opportunity to recall the fundamental principles that guide our monetary policy
in general. Second, I will discuss how we can use separately standard and non-standard
monetary policy measures in order to fulfil our price stability mandate in a context of
continued high uncertainty as regards economic growth, fiscal sustainability and the stability
of the financial sector. Third, I will describe some non-standard monetary policy measures
we took in greater detail, elaborating on how they help correcting distortions in the monetary
transmission mechanism induced by financial contagion.
1. The quest for price stability and the outlook for 2012
Let me start with the conjunctural situation and the outlook for 2012 in the context of general
key principles of sound central banking that are of particular importance at the current
juncture. The ECB has the clear and unambiguous mandate to maintain price stability in the
euro area. More precisely, we aim at maintaining inflation rates in the euro area below, but
close to, 2% over the medium term. Having a clear and overriding objective of maintaining
price stability is one of the key principles of "sound" central banking. This principle has been
supported by a growing and ever more refined wealth of research.1 Overall, although not the
exclusive objective of central banks, maintaining price stability is ultimately the responsibility
of monetary policy. It is therefore the necessary and central contribution that monetary policy
can make to the economic welfare of our citizens. This is why the Treaty enshrines it as the
ECB's primary objective.
With inflation averaging about 2% in the euro area since 1999, and thus better than what was
achieved in individual euro area countries before the introduction of the euro, we have
witnessed a period of relatively stable prices since the start of monetary union. Inflation
expectations have been, and remain, well anchored at levels in line with our quantitative
definition of price stability, despite several shocks that euro area economies have been
confronted with over this period - most notably the current financial and economic crisis. This
is first of all so because the ECB has - from its start - credibly delivered upon its primary
mandate, price stability.
In fact, by anchoring inflation expectations, a kind of "automatic stabiliser" is implemented.
Changes in nominal yields induced by monetary policy decisions are reflected into changes
in real yields, so as to dampen the destabilising effects of excessive uncertainty, both on
financial markets and the real economy. This is true also in normal circumstances, but it is
especially important when there are risks of deflation. During the crisis, well anchored
inflation expectations helped to avoid deflationary spirals and allowed the ECB to effectively
reduce short-term real interest rates by acting on the nominal, policy rate.
Our robust and medium-term oriented monetary policy strategy has been crucial in credibly
anchoring inflation expectations. Using the same framework for internal analysis and external
communication has helped the ECB to conduct its monetary policy in a credible, consistent
and effective manner.
This brings me to today's monetary policy decision. The Governing Council decided to lower
the key ECB interest rates by 25 basis points, following the 25 basis point decrease on
3 November 2011. Inflation is likely to stay above 2% for several months to come, but it will
decline to below 2% during 2012. The intensified financial market tensions are continuing to
dampen economic activity in the euro area and the outlook remains subject to high
uncertainty and substantial downside risks. In such an environment, cost, wage and price
pressures in the euro area should remain modest over the policy-relevant horizon. At the
same time, the underlying pace of monetary expansion remains moderate. Overall, it is
essential for monetary policy to maintain price stability over the medium term, thereby
ensuring a firm anchoring of inflation expectations in the euro area in line with our aim of
maintaining inflation rates below, but close to, 2% over the medium term. Such anchoring is
a prerequisite for monetary policy to make its contribution towards supporting economic
growth and job creation in the euro area. This assessment is also reflected in the
December 2011 Eurosystem staff macroeconomic projections for the euro area, which
foresee annual real GDP growth in a range between 1.5% and 1.7% in 2011, between -0.4%
and 1.0% in 2012 and between 0.3% and 2.3% in 2013. Compared with the September 2011
ECB staff macroeconomic projections, there is a narrowing of the range of the real GDP
growth projection for 2011 and a significant downward revision of the range for 2012.
The Governing Council continues to view the risks to the medium-term outlook for price
developments as broadly balanced. On the upside, the main risks relate to further increases
in indirect taxes and administered prices, owing to the need for fiscal consolidation in the
coming years. The main downside risks relate to the impact of weaker than expected growth
in the euro area and globally. In our assessment, substantial downside risks for the economic
outlook for the euro area exist in an environment of high uncertainty. Nevertheless, the
modelled probability of a deflationary episode is still very small indeed, even if it has recently
slightly increased.
The ECB's institutional and operational independence2 is fundamental when designing the
appropriate responses to the challenges posed by the crisis. The implications for the risk to
price stability of the turbulent gyrations in financial markets' sentiment led central banks
- including the ECB - to bring interest rates down to unprecedented levels and to engage in
a number of non-standard monetary policy measures. When entering these "uncharted
waters" it was and very much remains of paramount importance for the central bank's
measures to be effective that market participants never doubt about their consistency with
the overall policy framework. It is precisely because measures were taken in such
consistency and in full independence that market participants have never come to doubt the
ECB commitment to maintain price stability over the medium-term. Ultimately, independence
reinforces credibility, maximising the effectiveness of the measures implemented during the
crisis. Let me therefore dedicate most of the remainder of this speech to our non-standard
monetary policy and how it relates to standard interest rate policy.
2. Monetary policy, financial stability and the separation principle
The ECB was one of the first central banks to react with large liquidity injections, when the
financial market turmoil erupted in August 2007. This "prelude" was followed by a series of
non-standard monetary policy measures spanning our Enhanced Credit Support that started
after the demise of Lehman Brothers in September 2008 and our Securities Markets
Programme when the financial crisis turned into a sovereign debt crisis in May 2010. I wish
to discuss two fundamental issues related to such non-standard monetary policy before I
give a more detailed account of several of the adopted measures.
I have just emphasised that inflation expectations have remained well anchored over the
crisis period, in line with our objective of price stability. At the same time, we expect inflation
to return below 2% in the course of 2012. The first question is then, how do non-standard
monetary policy measure help fulfil this objective?
The second general issue that I wish to discuss is related to the unprecedented nature of
non-standard policies. The novelty of these tools implies that we have no track record on
their broader economic effects. Could non-standard measures have unintended
consequences on the monetary policy stance - consequences which may ultimately
endanger the ECB's ability to maintain price stability?
Regarding the first issue, it is straightforward to recognise that non-standard measures
ultimately serve our primary objective, once the medium term orientation of our strategy is
recognised. The medium-term orientation acknowledges the futility of attempting to fine-tune
price developments over very short periods of time This is due to long and variable lags in
monetary policy transmission and to inevitable price shocks. From the very outset, the ECB's
monetary policy strategy acknowledged that it is neither feasible nor desirable for inflation to
be targeted on a short term basis. While anchoring longer-term inflation expectations at
levels consistent with price stability, it explicitly recognised the need to avoid excess volatility
in other variables - notably output and nominal interest rates.3
The desire to avoid excess macroeconomic volatility, however, is not limited to output and
nominal interest rates. For example, it can be used to contain imbalances in financial
markets and asset prices, if their slow accumulation poses a threat to macroeconomic and
price stability over the longer term.
Along these lines, financial stability enters the horizon of the central bank, naturally and on a
permanent basis. When the accumulation of financial imbalances that are accompanied by
excessive monetary and credit growth endangers our ability to maintain stable prices over
the medium term, we have the obligation to take appropriate action. When, as is clearly the
case at present, financial instability in some market segments prevents a normal functioning
of the economy and of the monetary policy transmission mechanism, we must intervene to
restore our capacity to ensure price stability over the medium term.
The ECB interventions during the crisis have therefore been entirely consistent with the
principles of our monetary policy strategy and its medium-term orientation. The provision of
liquidity to prevent a collapse of sound financial institutions during a liquidity crisis is also
consistent with the broader ESCB's responsibility to contribute to financial stability. This is in
line with the provisions in the Treaty, which gives the ESCB the competence, without
prejudice to the primary objective of price stability and to the ECB independence, to support
the general policies of the European Union and notably to contribute to the smooth conduct
of policies pursued by the competent authorities relating to the stability of the financial
system.4 Most central banks have performed such a role as financial lender of last resort to
the banking sector in history when severe crises struck.5
Nevertheless, the second fundamental issue comes to the fore, raising the question about
the possible risk that the non-standard monetary policy measures may produce unintended
consequences for the monetary policy stance.
This concern has been in the mind of the Governing Council from the outset of the crisis. It
has led to the adoption of a clear guiding principle in the implementation of non-standard
measures: the separation principle.
The separation principle is the acknowledgement that standard and non-standard monetary
policy instruments have different purposes. A decision by the Governing Council on the
interest rates aims to signal to financial market participants its assessment of the monetary
policy stance. Changes in the key ECB rates ultimately affect inflation trough changes in
bank lending rates, credit conditions and aggregate demand. Under normal financial market
conditions, this transmission mechanism from standard policy decisions to prices is effective.
An appropriate setting of the rate on the main refinancing operations, or MRO rate, allows us
to signal the policy intentions of the Governing Council and thereby maintain price stability
over the medium term and ensure a firm anchoring of inflation expectations. Under normal
financial market conditions, non-standard monetary policy measures are unnecessary.
However, exceptional circumstances require extraordinary measures. The scope of
nonstandard measures that the ECB has used so far has to be explained as they are clearly
delimited: they aim to ensure that dysfunctions in some financial market segments do not
lead to severe disruptions in the monetary policy transmission mechanism, which could
compromise our capacity to ultimately affect prices through our interest rate decisions. From
this perspective, non-standard measures are a complement, rather than a substitute, of
standard interest rate decisions: they help ensure that standard policy produces its intended
effects, rather than aiming to impart additional relaxation to the overall monetary policy
stance.
This feature distinguishes the non-standard monetary policy measures the ECB used so far
from quantitative easing policies as pursued by other major central banks, because
quantitative easing is designed as a substitute for standard interest rate policy when central
bank rates have reached levels close to their zero lower bound and cannot be lowered
further. This feature also illustrates that the introduction of non-standard measures does not
imply the need for the ECB to manage a trade-off between short run inflation volatility and
price stability in the longer run. The non-standard monetary policy measures that we have
used so far are rather the means to ensure that standard ECB decisions can be effective at
all horizons.
There should therefore be no concern that our non-standard measures may produce
spillovers on the ECB's ability to maintain price stability. Thanks to the possibility to separate
standard and non-standard monetary policy actions, our non-standard measures do not
restrict in any way our capacity to tighten the monetary policy stance when necessary. This
has been clearly demonstrated by the Governing Council's repeated decisions to change
interest rates over the course of this year, while maintaining its non-standard monetary policy
measures. In turn, our non-standard measures are temporary in both their nature and scope.
Once the impairments to the transmission process disappear they can be phased out,
whereas the standard interest rate policy remains. In fact, many of our non-standard
monetary policy measures phase out automatically, for example long-term refinancing
operations at fixed rates at extended maturities, if they are not explicitly renewed.
In spite of the separation principle, however, some commentators have raised concerns that
the large amount of liquidity currently available to euro area banks will turn into broad money
and credit, and eventually into a source of inflationary pressure. Non-standard measures
have indeed resulted in a sizable expansion of the ECB balance sheet. In the more of four
years between mid-2007 and end 2011, the Eurosystem balance sheet relating to monetary
policy assets6 grew from 438 EUR billion euros to a temporary peak on 25 June 2010 of
985 billion euros, and has decreased since then to currently 923 billion euros. This
corresponds to a rate of growth of close to 110%.
However, it should also be noted that the rate of growth of total Eurosystem balance sheet
between end-November 2007 and end-November 2011 was 88%, whereas for the Federal
Reserve's was 219% and for the Bank of England was 191%.
Central bank reserves are held by banks and are not part of money held by the non-financial
sector, hence not, per se, an inflationary type of liquidity. There is no acceptable theory
linking in a necessary way the monetary base created by central banks to inflation.
Nevertheless, it is argued by some that financial institutions would be free to instantly
transform their loans from the central bank into credit to the non-financial sector. This fits into
the old theoretical view about the credit multiplier according to which the sequence of money
creation goes from the primary liquidity created by central banks to total money supply
created by banks via their credit decisions. In reality the sequence works more in the
opposite direction with banks taking first their credit decisions and then looking for the
necessary funding and reserves of central bank money. As Claudio Borio and Disyatat from
the BIS put it: "In fact, the level of reserves hardly figures in banks' lending decisions. The
amount of credit outstanding is determined by banks' willingness to supply loans, based on
perceived risk-return trade-offs and by the demand for those loans."7 In modern banking
sectors, credit decisions precede the availability of reserves in the central bank. As Charles
Goodhart pointedly argued, it would be more appropriate talking about a "Credit divisor" than
about a "Credit multiplier".8
One can obviously monitor developments in monetary and credit aggregates to check if the
concern regarding inflationary risks is justified. The ECB does this on a regular basis through
its monetary analysis, so we are well positioned to react to any signs of excessive money
and credit growth which may pose risk to price stability over the medium term.
If we look at broad money, however, it becomes clear that the underlying pace of monetary
expansion remains moderate. At the end of 2008 - the period of the maximum rate of
increase in the ECB balance sheet - the rate of M3 growth fell rapidly. From a peak of over
10% over 2007, the annual growth rate in M3 slowed down to zero at the end of 2009, before
turning positive again, though around moderate levels, during 2010 and 2011. From January
to October 2011 in relation to the same period last year M3 has increased just by 2.2% and
in the month of October M3 has even decreased by 59 billion euros in absolute terms.
Hence, while close scrutiny of future developments remains warranted, the evolution of M3 is
not suggestive of any undesirable spillovers from non-standard monetary policy measures on
the prospects for price stability. This confirms that the availability of central bank liquidity
worked mainly, as intended, as a means to offset underlying funding tensions for banks. The
large expansion of the ECB balance sheet was therefore instrumental in preventing a larger
decline in M3. It is conceivable that, in the absence of non-standard measures, broad money
growth could have fallen much further - possibly to the large, negative levels observed
during the 1930 ́s Great Depression in the United States.9
3. Contagion, the monetary transmission mechanism and non-standard
monetary policy
Let me now turn to a more detailed discussion of the non-standard measures implemented
by the ECB. These measures must be tailored to the specific market segment, and to the
specific disruption, which may prevail at a certain point in time. Therefore, there cannot be a
single non-standard policy tool: different tools must be activated depending on the particular
impediment to the transmission of changes in the standard policy rate to the economy. Two
months ago I argued that financial contagion - both between debt markets of different
sovereigns and between sovereigns and banks - is one major force at work that impairs the
functioning of the monetary policy transmission mechanism.10 This is still the case today; if
anything contagion dynamics have worsened rather than eased.
Contagion already played an important role at the beginning of the financial crisis, then in
terms of the propagation of illiquidity in interbank markets. The measures implemented
starting in September 2008 had the specific objective of addressing the evaporation of
liquidity in the money market, which seriously impaired a key source of funding for banks and
thus their ability to continue lending to households and businesses. The money market
"freeze" and liquidity contagion was, at least in large part, due to asymmetric information on
other banks' creditworthiness - in turn related to their exposure to toxic asset backed
securities. As such, it could not have been cured by a reduction in key ECB rates. The latter
could have dealt with a possible increase in interbank rates due to larger counterparty risk
premia, but not to a situation of liquidity hoarding and market breakdown.11 Moreover, a
sharp reduction in key ECB rates aimed at reducing banks' cost of funding would also have
had unwarranted repercussions on the overall monetary policy stance.
In contrast, the ECB decision addressed banks' funding problems directly. In the aftermath of
the failure of Lehman Brothers, the ECB launched its policy of "enhanced credit support", a
series of measures to enhance the flow of credit above and beyond what could be achieved
through policy interest rate reductions alone. These measures include the unlimited provision
of liquidity through "fixed rate tenders with full allotment"; the provision of liquidity at
lengthened maturities of up to one year; and the provision of more liquidity in foreign
currencies to euro area banks and of euro liquidity to other central banks for them to provide
to their local banks; and a programme of purchases of covered bonds. As banks can only
make use of the ECB liquidity-providing facilities if they have sufficient collateral, the ECB
also extended the list of assets it accepts as collateral, subject to appropriate haircuts. As it
had been the case in the years before the crisis, we also adjusted collateral eligibility criteria
in view of market developments in order to remedy evolving inconsistencies and avoid
possible abuses. The total value of eligible marketable collateral is very large. It equals about
EUR 13 trillion,12 which amounts to about 140 percent of euro area GDP. From this total, the
euro area banks have in their balance sheets about EUR 4 trillion with EUR 1.8 trillion
already approved for utilisation and creates the necessary room for manoeuvre in our
liquidity provision that right now amounts to just EUR 650 million.
Thanks to the enhanced credit support, banks with funding needs could simply obtain
liquidity from the ECB and continue operating almost "as if" the money market freeze had
never occurred. Clearly, the full allotment decision could have been taken, and would have
been equally effective, even in the absence of any changes in key ECB rates. The fact that
interest rates were also cut rapidly over the period after September 2008 is due to the
contemporaneous deterioration of the outlook for price stability. The non-standard measure
implemented in 2008, however, prevented at source any severe disruption in the monetary
policy transmission mechanism and thus ensured that the policy easing could produce its
intended effects.
This example illustrates that, as I have argued before, once non-standard measures are
appropriately implemented, they can be thought of as being independent from the process of
interest rate setting. There is however a prerequisite for such independence: an appropriate
operational framework involving the remuneration of banks' reserves. This feature ensures
that banks can hold increasingly large amounts of liquidity without suffering an increasingly
hefty opportunity cost. A full allotment procedure such as that applied by the ECB could thus
completely offset the effects of the money market freeze. If reserves had not been
remunerated, however, banks under financial distress would have had to go above the
minimum reserves to build appropriate liquidity buffers with the ensuing increase in their
opportunity cost. The ECB could have induced banks to satisfy their demand for liquidity only
through a contemporaneous reduction of the opportunity cost of reserves, which is the policy
interest rate. The separation principle would have been broken.13
A similar application of the separation principle has been made with the more recent SMP,
which the ECB introduced in response to the repercussions of the euro area government
debt crisis. Under the SMP the Eurosystem buys securities in dysfunctional debt market
segments in order to safeguard the transmission of monetary policy.
This framework has enabled the ECB to quickly respond to the market tensions resurfacing
over the summer of 2011. Let me briefly recapitulate the most recent measures. On
10 August, the ECB has again provided liquidity at a maturity of six months. On
15 September, the ECB has announced three additional US dollar operations with a maturity
of about three months, which cover the end of the year. Importantly, the ECB has, in
response to disorderly conditions in euro area debt securities markets, resumed the active
implementation of the SMP on 8 August to buy debt securities, though only in the secondary
government bond market. The SMP aims to create a better functioning transmission
mechanism of monetary policy to all parts of the monetary union and is in full compliance
with the prohibition of monetary financing. The relative size of the programme, representing
just 1.9% of the euro area GDP against 13.7% of GDP that has been bought by the Bank of
England or the 11.4% purchased by the Federal Reserve, makes it easier to be fully
sterilised.
Furthermore, at the recent October 6 meeting, the ECB decided to conduct two further
oneyear long-term refinancing operations; to continue to apply fixed rate full allotment
procedures in all monetary policy liquidity-providing operations for as long as needed and at
least until the middle of 2012; and to conduct a second Covered Bond Purchase Programme
(CBPP2) with an intended purchase amount of EUR 40 billion and over a period of one year,
which started last month. On 30 November, the ECB announced coordinated actions with
other central banks to enhance the capacity to provide liquidity support to the global financial
system.
Today, the Governing Council also decided to adopt further non-standard measures. They
include the conduct of two longer-term refinancing operations (LTROs) with a maturity of
3 years as fixed rate tender procedures with full allotment, and with the option of early
repayment after one year; to increase collateral availability by reducing the rating threshold
for certain asset-backed securities (ABS); to grant eligibility for Eurosystem operations to
ABS having a second best rating of at least "single A" in the Eurosystem harmonised credit
scale at issuance, and at all times subsequently, and the underlying assets of which
comprise residential mortgages and loans to small and medium-sized enterprises; to allow
national central banks to accept as collateral additional performing credit claims (namely
bank loans) that satisfy broadly revised eligibility criteria; to reduce the reserve ratio, which is
currently 2%, to 1%; and to discontinue for the time being, as of the maintenance period
starting on 14 December 2011, the fine-tuning operations carried out on the last day of each
maintenance period.
These measures should ensure enhanced access of the banking sector to liquidity and
facilitate the functioning of the euro area money market. They are expected to support the
provision of credit to households and non-financial corporations. All the non-standard
monetary policy measures are, by construction, temporary in nature.
If we look at the past experience, the ECB's measures have enabled the monetary policy
transmission mechanism to continue operating relatively well at the level of the euro area,
containing also contagion, although it should be recognised that the transmission mechanism
remains severely disrupted in some euro area countries.
In sum, our actions - standard and non-standard - were fast, targeted and decisive; and
clearly within the ECB's mandate. But the main responsibility for solving the European
sovereign debt crisis and the continuing financial crisis rests with EU authorities and Member
States' governments. All these authorities have to live up to their responsibilities, comply with
previous commitments and swiftly implement agreed reforms. It is now of particular
importance that all parties move ahead of financial markets, rather than sticking to a purely
reactive approach. Under no circumstances can authorities relax efforts under the
assumption that the ECB could alone compensate for the lack of action of others.
4. Concluding remarks
Let me conclude by emphasising the key messages I wanted to convey today.
First, based on the information available today, we expect to see inflation to stay above 2%
for several months to come, but it will decline to below 2% during 2012.
Second, our determination to maintain price stability for the euro area as a whole over the
medium term has made it necessary for us to intervene in dysfunctional market segments,
thereby also contributing to the stability of the euro. We have already done a lot in this regard
and we are ready to continue doing so, while remaining completely committed to our primary
objective. The ECB is also open-minded to extending its non-standard monetary policy within
its mandate, when circumstances require, as we have shown today. Overall, we have the
available tools.
Third, in setting our monetary policy for the euro area we take full advantage of the principle
of separation between standard and non-standard monetary policy. This principle suggests
that actions on both sides can be taken independently. Moreover, our non-standard policy
measures, for example taken in order to remedy adverse effects of financial contagion on the
monetary transmission mechanism, are fully aligned with the ECB's mandate and monetary
policy strategy.
Fourth, the ECB is able and willing to continue fulfilling central banks' classical role as
financial lender of last resort, handling liquidity problems in the financial system without
endangering price stability.
I thank you for your kind attention.