Mario Draghi: Monetary policy communication in turbulent times
Speech by Mr Mario Draghi, President of the European Central Bank, at the Conference "De
Nederlandsche Bank 200 years: central banking in the next two decades", Amsterdam,
24 April 2014.
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Summary
Communication and transparency have become more important for central banks like the ECB in recent
decades, and will become even more important in the decades to come. A transparent central bank is not
only more accountable, but also more effective in implementing its monetary policy. If the general public
and financial markets can understand how the ECB is likely to respond in a given situation - its so-called
"reaction function" - they can form reasonable expectations about future monetary policy. This in turn gives
the ECB the capacity to influence interest rates at longer maturities and steer broader financial and
economic conditions.
While such "management by expectations" worked relatively well in normal times, the crisis inevitably made
our decision-making process more complicated and our policies more difficult to understand. For example,
the use of unconventional measures implied a wider range of possible monetary policy responses to a given
shock. To continue to steer expectations in this environment, the ECB had to be more explicit in its
communication. This involved reaffirming our mandate and explaining its medium-turn orientation and euro
area perspective. Furthermore, the Governing Council will be equally active in guarding against inflation and
deflation. And, faced with the effective lower bound and different contingencies, we had to explain our future
policy intentions and clarify our more complex reaction function.
With our forward guidance, we aim to give guidance on the expected level of future interest rates, and to
remove uncertainty about that level by strengthening communication on our reaction function. We have also
further simplified our reaction function by laying out some contingencies that would warrant a monetary
policy reaction. These are, first, an unwarranted tightening of monetary policy stance (from developments in
short-term money markets, global bond markets or foreign exchange markets) that could be tackled through
more conventional measures. Second, a further impairment in the transmission of our stance, in particular
via the bank lending channel, for which a targeted LTRO or an ABS purchase programme might be the right
response. Third, a worsening of the medium-term outlook for inflation, which would warrant a more
broadbased asset purchase programme. The Governing Council is committed - unanimously - to using both
unconventional and conventional instruments to deal effectively with the risks of a too prolonged period of
low inflation.
Despite these efforts to enhance transparency, the predictability of the past will not readily return. Hence,
judgement is likely to play a greater role in decision-making, and this involves trade-offs that need to be
explained. That is why the Governing Council has been reflecting on the publication of a record or account
of its policy deliberations. Such a written account would provide a more detailed explanation of the
reasoning behind the Governing Council's decisions, and give a sense of the discussion and the main
arguments.
Any written account needs to preserve the independence of the Governing Council members and the
collegiality of their decision-making. Releasing an account of the main arguments considered, in a
nonattributed form, should on balance achieve these goals. Such a release should complement the real-time
messages conveyed in the press conferences and offer additional information to improve understanding of
our reaction function.
* * *
Dear Klaas,
Ladies and gentlemen,
Thank you very much for inviting me to speak at this conference marking the bicentenary of
De Nederlandsche Bank (DNB). Congratulations to you, Klaas, and to all the staff of the
DNB!
We are tasked today with reflecting on central banking in the next two decades, and the
theme I would like to talk about is central bank transparency and communication. This is not
only because transparency and communication has grown ever more important for central
banks over the past twenty years, and look set to become even more important over the two
decades to come. It is also because the Netherlands seems a fitting setting for such a
discussion.
As you know well, this country has a long history of transparency - households in the
Netherlands are renowned for keeping open their curtains. The classic explanation is that
people do this for the benefit of others: with nothing to hide, they are happy to grant
passersby a look inside. Another explanation I have heard is that people do it for themselves: in dark
Northern European climates, they simply want to let more light into their houses. But
whatever the motivation, what matters is that an open curtain benefits both those on the
outside and those on the inside. The same is true for us as central banks.
A transparent central bank serves the general public, by improving understanding of its
actions and accountability for its decisions. And a transparent central bank contributes to its
own mission, by steering expectations and making its monetary policy more effective. Let me
therefore begin by explaining how central banks across advanced economies, and the ECB
in particular, have taken up the challenge of transparency and openness.
Transparency and monetary policy effectiveness
Up until the early 1990s, central banks tended to be rather secretive institutions, inclined to
lock away their thinking like the gold in their vaults1. Remember that it was only in 1994 that
the Federal Reserve decided to make its interest rate decisions public. Before that, markets
had to guess whether or not the FOMC had changed its federal funds rate target.
Today, however, central banks have realised they are more likely to fulfil their mandates if
they inform the public and the markets about their strategies, assessments and policy
decisions in an open, clear and timely manner.2 Also, the granting of more independence to
central banks called for a commensurate increase in accountability to the wider public.
Central banks responded and opened up.
The ECB has faced the same expectations of openness, not least given the particular
challenges for democratic legitimacy in a multi-country monetary union. From the start, we
have fully embraced the merits of being transparent and accountable. For example, we were
the first major central bank to hold a regular press conference immediately after our monthly
policy meetings to explain our decisions in real-time. We also report regularly to the
European Parliament.
Moreover, we have recognised that, in a market economy, transparency and communication
are central to the effectiveness of our monetary policy.3 First, having a clear objective
supports credibility and helps anchor inflation expectations. Second, adopting an explicit
monetary policy strategy helps markets and the public understand how the central bank is
likely to respond to economic and monetary developments - its so-called "reaction function".
Together, a credible objective and a well-understood reaction function allow financial markets
and the public to form reasonable expectations about our future interest rate policy. This in
turn gives us the capacity to influence interest rates at longer maturities and steer broader
financial and economic conditions. This is what Mike Woodford has called "management by
expectations".4
In the pre-crisis times, these expectation effects worked relatively smoothly. We had - and
still have - a clear objective given to us by the Treaty, price stability. In 1998 we provided a
quantitative definition of price stability, clarifying in 2003 that we aimed at inflation rates
"below, but close to, 2%" over the medium-term. We deployed a single standard monetary
policy instrument to reach that objective - the main ECB interest rates. And our reaction
function could be understood well, based on our strategy and actions, and ex post could be
broadly captured by simple policy rules, such as the Taylor rule, in the same way as for other
central banks.5
The need for more communication during the crisis
In crisis conditions, however, the implementation of monetary policy inevitably changed. We
were forced to turn to unconventional measures to fulfil our mandate, for two main reasons.
First, we faced severe impairments to the transmission of monetary policy across the euro
area, with marked heterogeneity from country to country. This called for unconventional
measures tailored to the specific frictions at hand. Second, like many other central banks, we
had to operate in an environment where our standard monetary policy instruments, the
shortterm policy-controlled interest rates, became increasingly inhibited in the vicinity of the
so-called zero lower bound.
In these circumstances, understanding our decision-making process became more
complicated - and this was true for all major central banks. Simple policy rules became less
useful to describe our policies, meaning signals were harder to extract. And the use of
unconventional measures implied that there was a wider range of possible monetary policy
responses to a given shock. Thus, to continue to steer expectations about future policy, we
had to be more explicit about how we understood this new environment.
Our response was to place more emphasis on enhanced communication - both regarding
our commitment to our price stability objective, and regarding our assessment of and
response to the rapidly changing economic and financial situation. Let me explain why both
were necessary.
Reaffirming the price stability objective
The crisis has of course not altered our price stability mandate, which is defined in primary
law, in the Treaty. Nonetheless, the events of recent years have made it important for the
ECB to reaffirm that mandate - specifically, to explain its medium-term orientation and its
euro area perspective. Furthermore, the Governing Council will be equally active in
responding to medium-term developments in inflation that fall short of our objective as to
those that exceed it.
This is especially important given the unique features of this crisis. It is a crisis that originated
from excessive leverage and has bequeathed a debt overhang in many developed
economies, and, in the case of the euro area, also a loss of competitiveness in a number of
countries. Students of economic history know that in past episodes debt overhangs have
been reduced through higher inflation. Higher inflation also makes competitiveness
adjustments easier. Thus, fears might easily have arisen that we might be tempted to do the
same, especially in the light of some of the unconventional measures we have taken.
Underlining our price stability mandate is essential to remove any doubt about future excess
inflation.
By the same token, the aftermath of a debt crisis often leads to a prolonged period of
balance sheet adjustment, low economic growth and possible risks of a debt deflation spiral.
Such broad-based deflation risks are not what we see in the euro area today, where it is
mainly falling food and energy prices combined with weak demand that have pushed inflation
into low territory. In these circumstances, inflation nonetheless becomes more vulnerable to
any further downward shock. Reiterating our price stability objective helps here, too, by firmly
anchoring medium-term inflation expectations near 2%. In other words, emphasis on the
symmetry of our objective helps contain both inflationary and deflationary expectations.
With this heightened vulnerability to shocks, equally important has been emphasising the
medium-term orientation of our monetary policy. This orientation implies that there are types
of shocks that are relevant for our price stability assessment, and those that are not. The
relevant type of shocks are those that are likely to persist into the medium-term and affect
medium-term inflation expectations. Communicating clearly this distinction allows the public
to understand how monetary policy will respond when a given shock hits, and in turn to have
well-anchored inflation expectations. While inflation will remain low for a prolonged period,
we see it gradually rising back to 2%. The delay is largely explained by the impairments in
the transmission mechanism that lengthen the lag between our accommodative policy stance
and price developments.
Finally, given the need for relative wage and price adjustments between parts of the euro
area, the crisis has made it more necessary to recall that monetary policy is geared to the
euro area as a whole. During an adjustment in relative prices, there will always be some
jurisdictions where inflation rates fall substantially below the euro area-wide objective, while
inflation rates will naturally have to exceed the objective elsewhere. In this context, our role is
to remain clearly focused on achieving price stability for the euro area; we cannot make
policy in favour of subsets of countries. This is because our legitimacy flows from the Treaty,
which establishes our constituency as the whole euro area. And it is only by respecting this
that we justify our powers and independence.
Explaining a more complex reaction function
Nevertheless, even with a transparent and credible objective, crisis conditions make it
unavoidably harder for observers to predict how we will respond to unusual and sometimes
unforeseeable circumstances, and which measures could be deployed. This in turn makes it
harder for monetary policy to steer expectations about future policy. There are two main
challenges here.
First, when central banks come up against the effective lower bound, the possibility
disappears to use current changes in the short rate to signal the policy response to a
changing inflation outlook. There is therefore less information on which to base future interest
rate expectations, which in turn implies that the central bank has less traction over the shape
of the yield curve and economic conditions. Thus, it becomes more important to
communicate directly about future interest changes and their response to a changing
economy, i.e. to give forward guidance.
Second, the different contingencies in crisis conditions and the policy measures associated
with them are unfamiliar to the public. This makes understanding our reaction function more
complex. Hence, the probability distribution of outcomes tends to widen, the number of
economic and financial variables that observers consider relevant for monetary policy and its
transmission increases, while the yield curve becomes less informative as a summary
indicator. To accurately steer expectations across a wider array of measures, more active
communication on our reaction function is needed.
The purpose of enhanced transparency is to respond to these challenges: to reduce
uncertainty about our future policy intentions and to clarify our reaction function in unusual
circumstances. Let me explain.
First, forward guidance enhances transparency through two channels. It gives guidance on
the expected level of future interest rates, conditional on the outlook for price stability. And it
reduces uncertainty about that level by strengthening communication on our reaction
function. Specifically, we have communicated that, given low inflation and broad-based
economic weakness, we expect interest rates to stay at present or lower levels for an
extended period of time.
This communication has indeed had the overall effect of lowering longer-term rates and
partly insulating euro area money markets against developments elsewhere. Forward
guidance has also reduced uncertainty related to our reaction function. Implied densities
extracted from EURIBOR options and used to gauge expectations of the forward OIS rate
show that the dispersion of short-term rate expectations has declined to levels closer to
those observed in early May 2013, after we cut interest rates. The sensitivity of money
market forward rates to macroeconomic data releases has declined as well. And note that by
cutting rates in November last year we followed up words with actions, which effectively
strengthened our forward guidance.
We have also recently helped further clarify our reaction function by laying out some
contingencies that would warrant a monetary policy reaction. These contingencies illustrate
well the multiple dimensions of our reaction function, both as regards the risks to price
stability, and as regards the array of instruments we have at hand to deal with those risks.
One contingency would be an unwarranted tightening of the policy stance. Such a change in
the policy stance could emanate from at least three sources.
First, a need for action could emanate from renewed tensions in short-term money markets
to the extent that these are propagated to the medium-term curve, in particular in an
environment of receding excess liquidity in the euro area. This is distinct from the type of
short-term money market volatility we saw towards the end of last year that was associated
with technical factors.
Second, a tightening of the policy stance may arise from developments in global bond
markets that unduly spill over to the interest rate term structure in the euro area. So far our
forward guidance has managed to decouple euro area forward curves somewhat from
developments in the US.
Third, the policy stance may also be affected by a continued appreciation of the exchange
rate. The exchange rate is not in itself a policy target, but a rise in the exchange rate, all else
being equal, implies a tightening of monetary conditions, a downward impact on inflation and
potentially a threat to the ongoing recovery. If so, this would call for policy action to maintain
the current accommodative stance. This is why we have said that the exchange rate is an
increasingly important factor in our assessment of the outlook for price stability.
This assessment, however, needs to take in the whole picture. To the extent that the
exchange rate is rising because confidence in the euro area is returning and capital inflows
are increasing, this leads also to looser financing conditions. While exchange rate
appreciation contributes to low inflation in the short run, falling long-term rates support rising
inflation over time, insofar as they are passed on into lower bank lending rates and stimulate
demand. As a result, the overall policy stance has to take this balance of forces into account.
What would be our policy response should this contingency arise? In our view an undue
tightening of the policy stance can be addressed through a variety of more conventional
measures. These include a further lowering of the interest rate corridor, including a negative
deposit rate. They include a further extension of the fixed-rate full allotment procedure,
beyond the period currently envisaged. Remember that in November 2013 we announced
our decision to continue conducting the main refinancing operations (MROs) as fixed-rate
tender procedures, with full allotment, at least until July 2015. Finally, if necessary, the
measures could include new liquidity injections via our liquidity operations, including
longerterm fixed-rate operations.
Another contingency that would warrant a monetary policy reaction would be further
impairments in the transmission of our stance, in particular via the bank lending channel.
Given the reduction in bank funding costs over the last year and the ongoing clean-up of the
banking sector through the comprehensive assessment, our assessment is that bank lending
conditions are improving and will continue to improve.6 Yet if this scenario does not
materialise, we may have to respond. This could take several forms, including a longer-term
refinancing operation targeted towards encouraging bank lending or an ABS purchase
programme, supported by the necessary regulatory changes aimed at revitalising high quality
securitisation in Europe.
A third contingency would be a worsening of the medium-term outlook for inflation. One
cause for this could be by a broad-based weakening of aggregate demand that derails our
baseline scenario of a moderate recovery. Another cause could be a substantial positive
supply shock that, given the current low level of inflation, loosens the anchoring of
mediumterm inflation expectations. Unlike the other contingencies, the objective here would not be to
defend the current stance, but rather to increase meaningfully the degree of monetary
accommodation. Hence, the limited margin for manoeuvre that remains over short-term
interest rates would not be sufficient. This would be the context for a more broad-based
asset purchase programme.
Ultimately, all these contingencies point to the same conclusion: in order to fulfil its mandate,
the Governing Council is committed - unanimously - to using both unconventional and
conventional instruments to deal effectively with the risks of a too prolonged period of low
inflation.
Opening up the ECB's decision-making
In spite of these efforts to enhance transparency, and their observable effectiveness, there is
little doubt that our simpler understanding of monetary policy in the past will not readily
return. Policymakers are operating in a more complex and heterogeneous environment.
Structural breaks and model uncertainty imply that the regularities of the past can no longer
be relied upon. This in turn means that judgement plays a greater role in decision-making.
Yet, judgement always involves trade-offs, which are important for the public to understand
and for policy-makers to be accountable for. And while trade-offs exist in normal times, in
crisis conditions they become both more complex and more consequential. For example,
each of the unconventional measures that I discussed above could be effective in addressing
specific impairments in monetary transmission and risks to price stability, but could also have
side effects that need to be considered.
This is why last August I reported that the Governing Council felt a need for a "richer
communication of the rationale behind its decisions" so as to give a sense of the discussion
that has taken place. The Governing Council has since been reflecting on the publication of
some record or account of its policy deliberations. I would like to share with you my views on
this matter today.
A written account of our policy deliberations would provide a more detailed explanation of the
reasoning behind the Governing Council's decisions, and give a sense of the discussion and
the main arguments. This would allow the public and markets to further improve their
understanding of the Governing Council's reaction function, our assessment of the economy
and our policy responses in light of evolving conditions. For this reason, I am convinced that
it would be useful. Yet, we need also to be careful. We need to take proper account of the
specific institutional setting of the euro area and the unique communication challenges in a
multi-country monetary union.7
This implies, first, that any modifications we introduce in reporting on our monetary policy
deliberations must not put at risk or call into question the independence of the members of
the Governing Council. They act in a personal capacity in the interest of the euro area, rather
than as representatives of their countries of origin. To my mind this precludes the attribution
of positions to individual Council members, which could all too easily be misconstrued or
misinterpreted through a national perspective and expose the members to external
pressures, perceived or real.
Second, we need to ensure that any account of our proceedings preserves the collegiality of
the Governing Council's deliberations. For good reason Article 10.4 of the Statute stipulates
that the proceedings of the Governing Council meetings shall be confidential, while the
Council may decide to make the outcome of its deliberations public. This not only protects
the independence of the Council members, but also ensures an open and frank exchange of
views inside the Governing Council, which is essential for the effectiveness of our collegiate
decision-making.
Like any committee, the Governing Council benefits from the diversity of views and
perspectives that are brought to the table. At the same time, decision-making by committee
reflects more than the sum of the pre-established views of its individual members. What
counts is the quality of the arguments and the contributions made towards reaching a
common decision. There needs to be scope for a give-and-take in these discussions to reach
the best decisions. This implies a readiness to re-consider positions in the light of all
considerations brought forward in the course of the meeting - an approach that helps to
forge a consensus. An account should not limit the flexibility of Council members to reach
such a collective view. It should support collegiality, which comes at a premium in a
multicountry context.
My view is that releasing a more complete account of the main arguments considered in our
monetary policy deliberations, in a non-attributed form, will on balance serve to strengthen
the Governing Council's collegiate decision-making and communication. Such a release
should naturally complement the real-time messages conveyed in the press conferences. It
should offer additional information that improves understanding of our reaction function, with
respect to the relevant medium-term horizon, while taking care to avoid triggering short-term
market noise.
Conclusion
Let me conclude.
From the time the ECB was set up, not two centuries, but just 16 years ago, its commitment
to its price stability mandate has not wavered. But its conduct and communication of
monetary policy have evolved. The ECB's reporting obligations have, unsurprisingly, grown.
And as we take on banking supervisory powers later this year, there is a need for even
greater accountability and transparency, which has been reflected in our inter-institutional
agreement with the European Parliament.
The publication of a richer account of our monetary policy deliberations represents a logical
next step in the ECB's evolving communications. After 16 years of operation and seven
years of crisis, the Eurosystem has matured enough to engage more fully with the public
about how we go about fulfilling our mandate. Such an interaction is ultimately the best basis
for an effective monetary policy and for maintaining credibility and trust in our institution -
which hopefully, like the DNB, will last for centuries to come.
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