"Bold, but realistic: monetary policy and financial
stability"
 DNB
"Europe will not be made all at once, or according to a single plan. It will be built
through concrete achievements which first create a de facto solidarity. This
bold, but realistic quote from Robert Schuman, one of the founders of the
European Union, today, also guides monetary policy and financial stability." In
th
his keynote speech at the  Capital Markets Seminar, jointly organized by the
European Stability Mechanism, the European Investment Bank and the
European Commission, Klaas Knot discussed the current state of economic and
financial affairs.
Date:  June 
Speaker: Klaas Knot
Location: The th Annual Capital Markets Seminar, Luxembourg City
Good morning everyone.
Today is June th. A date of tremendous historical importance. The day that, exactly  years
ago, marked the beginning of the end of the Second World War. A day that you could see as
the beginning of what we now know as the European Union.
One of the founders of our Union was Robert Schuman. He was born just a stone's throw
from where we are today  right here, in Luxembourg City.
What a bold man. A bold, but realistic man.
"Europe," he said, "will not be made all at once, or according to a single plan. It will be built
through concrete achievements which first create a de facto solidarity."
And indeed, looking back, there was no single plan. But what we do see, when we look back,
are concrete achievements. Like our hosts today: the European Commission, the European
Investment Bank, and the European Stability Mechanism. And what we also see, when we
look back, is de facto solidarity. Between people, between countries, and in concrete
achievements like Next Generation EU.
The ESM is one of the youngest achievements in this very incomplete list.
A mere  years ago, at the height of the euro crisis, we did not have the ESM. We did not have
a European mechanism in place to deal with economic and financial stability issues. But many
of you here today realised that we needed one.
And it is testament to you, and all those involved, that the ESM has become, in a very short
time, a cornerstone institution of the European Monetary Union. During the sovereign debt
crisis, it was directly involved in successfully restoring market access to multiple euro area
member states. One quick look at today's relative borrowing costs tells a very convincing story
here.
Today, the sovereign debt crisis seems like something from the distant past. It was followed by
a pandemic and, soon thereafter, Russia's brutal and unjustified war on European soil. This
triggered an energy crisis that many European households and businesses still suffer from,
along with the revival of persistently high inflation.
As central bankers, we did not foresee all of this. It was not part of the plan. But we are
dealing with it. Because like Schuman's Europe, monetary policy and a stable financial system
will not be made according to a single plan either. They will be made step by step. One
concrete achievement after the other.
Until not so long ago, euro area inflation was persistently below our target of two percent
over the medium term. And although shortterm interest rates were near the effective lower
bound, inflation was not budging.
This led the ECB, and many other central banks, to deploy a range of "unconventional" tools
such as Targeted Long Term Refinancing Operations and large scale asset purchases. And
when the pandemic hit us, the pace and volume of purchases picked up substantially.
Of course, unconventional monetary policy instruments are not without risk. When central
banks increase their footprint in financial markets, the allocation of resources in the economy
will be distorted. And, by substantially lowering both shortterm and longerterm interest
rates, vulnerabilities in the financial sector and real economy will increase.
To be frank, policymakers were facing a tradeoff then, between mediumterm inflation
considerations and longerterm financial stability concerns. You can see how monetary policy
advanced step by step on the next slide.
Once the pandemicrelated measures gradually eased, demand recovered faster than many,
including myself, had anticipated. Combined with some lagging distortions in international
supply chains, this led to rising inflation.
And then Russia invaded Ukraine. On February th, . An act that will go down in history
like June th, , but for very different  in fact entirely opposite  reasons. More like
September st, . An act as unjustified as unforgiving.
Russia's attack had an immediate effect on Europe's energy supply. And it caused record high
and surprisingly persistent inflation in the euro area.
As a consequence, monetary policy needed to be tightened  quickly and decisively. So that is
what we did. We phased out our asset purchases and raised interest rates in an
unprecedented fashion. And this paid off. At its peak, headline inflation was . percent. Now,
it has come down to just above  percent. Clearly this is still way too high. But I do believe
that, in the absence of further supply shocks, the worst is behind us in terms of the immediate
assault on our citizens' purchasing power.
However, a strong word of caution is still in order. Because inflation was high for a long
period, underlying inflationary pressures have built up. As a consequence, we now observe
secondround effects  energy prices have found their way into other items in the consumer
basket, and wages and services in particular have taken over the inflation torch. It is likely that
price pressures in these areas will prove more difficult to bring down.
It has clearly been a decade of extremes for monetary policy. But despite all of this, inflation
expectations are still decently anchored, and let us hope that the next decade will not be so
eventful.
What we do in the realm of monetary policy, is, of course, aimed at having an effect on the
real economy and then onto inflation.
We know that this transmission always comes with a lag, whether monetary policy is easing
or tightening. But in the spirit of Robert Schuman, we do aim for concrete results. So it is
reassuring to see the first signs of recent monetary policy actually being transmitted to the
real economy.
On European capital markets, financial conditions have tightened. And euro area banks are
reporting tighter lending standards.
If you look at this graph, with the composite borrowing costs of both nonfinancial
corporations and households on the left, and credit growth on the right, you can also see that
interest rates for households and firms have increased faster than in previous episodes with
rising interest rates. This development is in line with the steeper policy rate path compared to
previous tightening cycles. We also see these higher rates reflected in lower credit growth in
the euro area.
The effect of monetary tightening can also be observed through macrofinancial indicators.
For example, over the past decade, euro area housing prices skyrocketed. In the Netherlands
they almost doubled. Now with the shift in monetary policy, we are observing the first
persistent decline in a long time  the number of transactions is going down and the number
of houses being sold above the asking price is sharply decreasing.
These are only the first, concrete steps in the transmission of our monetary policy tightening.
And we have yet to see their full effect.
So the current situation is one in which our monetary policy is killing two birds with one
stone: it is addressing mediumterm risks to price stability, while the direction of monetary
policy  in principle  aids in addressing longerterm financial stability concerns.
You would think this is a comfortable position for policy makers.
Nonetheless  a word of caution is in order here too. While mediumterm inflation and
longerterm financial stability policies are now more aligned, a shortterm financial stability
risk looms around the corner. An abrupt change in monetary policy requires a massive
adjustment in the financial system, which could also trigger some of the vulnerabilities that
have accumulated in the past.
As we know from theory, higher interest rates can be beneficial for financial institutions. They
underpin their profitability and solvability.
But do we also see this practice?
I have borrowed this graph from the ECB's most recent Financial Stability Review.
The panel on the right depicts the annual changes in operating profits and their drivers. The
dark blue part shows that in  the operating profit of European banks ballooned due to net
interest income. This can be attributed to the relatively sluggish interest rates on saving
deposits. It is expected that such passthrough will increase further this year.
But moving from theory to practice, things have a tendency to become a bit more unruly.
Testimony to this is the recent banking turmoil in the United States, where sharp increases in
interest rates were inadequately accounted for. And this ultimately led to a series of bank
failures. Against the backdrop of much tighter management and supervision of this socalled
interest rate risk in the banking book on this side of the Atlantic, similar banking failures have
not manifested itself in the euro area.
At the same time, I regard debt sustainability, in the broad sense, as one of the major financial
stability risks on either side of the Atlantic. And rising interest rates have brought this
vulnerability to the surface.
There is no linear correlation between the two  here at the ESM I do not have to belabour
the point made by Dornbusch and others that markets can regard debts as sustainable for
quite some period of time, before they no longer do. Such potential nonlinearities call for
additional caution.
Households are experiencing a real income squeeze, which compromises their debt servicing
capacity. Though some can benefit from having fixed their borrowing costs at extended
maturities during the lowforlong era, this only partially and temporarily cushions the blow.
And nonfinancial corporates face a similar situation. In the Netherlands, for example, 
percent of total debt of nonfinancial corporates will mature within the year or will have to be
refinanced at a likely higher interest rate. Higher interest expenditures might eventually also
trigger some corporate liquidity issues.
And alongside households and nonfinancial corporates, the debt sustainability of euro area
sovereigns is also affected by the recent rise in bond yields. Here too, the lowforlong era has
partially been lockedin with fixed borrowing rates spanning a relatively long horizon. But this
can only buy time rather than obviate the inevitable adjustment in the primary fiscal balance.
So I urge caution.
Even though our financial system has proven its resilience, largely due to the buffers we have
built since previous crises, and even though we have weathered the shocks of recent years, we
mustn't be complacent. Building resilience does not prevent shocks from happening. It just
helps us to deal with them.
So it is encouraging that we as central bankers, in deciding on our course of action, have
started to pay more attention to the interplay between monetary policy and financial stability.
Monetary policy affects the stability of the financial system. But in turn, we need a stable
financial system to effectively transmit monetary policy. Financial stability is a prerequisite
for mediumterm price stability.
And as Chair of the Financial Stability Board, I must underscore that a stable financial system
is also a goal to be pursued in its own right.
So where does that leave us?
Central bankers will have to continue tightening monetary policy for as long as necessary,
until we see inflation return to our two percent target over the medium term.
But we will do this step by step. Because the tighter monetary policy gets, the more forceful
its transmission to output and prices that is still largely in the pipeline. And with each step, the
financial system will have to continue adjusting to the higher interest rate environment. The
recent financial turmoil on the other side of the Atlantic illustrates that this cannot be taken
for granted.
And with each step, we continuously learn from our experiences.
Allow me to share with you two valuable lessons we have learned in recent years. Lessons
that will help us walk this tight rope  step by step. Lessons that will help us tackle future
challenges  and go from one concrete achievement to the next.
A first lesson from the recent episode is that the socalled separation principle can be
maintained for longer than some might have expected. According to this principle, a central
bank should clearly separate its function as lender of last resort from its function as monetary
policy maker.
Since the Global Financial Crisis, policy makers worldwide have become more experienced and
more innovative with various forms of lending operations. With this experience came a more
coherent and powerful toolkit. A toolkit that can, and in my view should, be used to adhere to
the separation principle for as long as possible.
Against the backdrop of a better regulated and better capitalised financial system, we can
now deal with a broad range of financial stability related risks without compromising on
mediumterm price stability.
The second lesson we have learned, is that moderate and contained levels of financial
turbulence do not necessarily have to be at odds with mediumterm price stability. Repricing
of risk in financial markets can contribute to tighter financial conditions for a given policy rate.
Monetary policy normalisation also entails a reduction of the central bank footprint in
financial markets, a decompression of term premia, and some repricing of risks. As long as
such repricing is not excessive, it can in fact be combined with a somewhat lower terminal
policy rate that would still be compatible with mediumterm price stability.
"Europe will not be made all at once, or according to a single plan. It will be built through
concrete achievements which first create a de facto solidarity."
Bold, but realistic.
Bold because it set out an ideal. An idea. A vision for Europe.
Realistic because achieving this would not happen overnight.
It would happen every time a step forward was taken. It would happen every time a concrete
result was achieved. It would happen through setbacks, shocks and surprises that were
overcome and learned from.
Over the past years, monetary and macroprudential policy makers have achieved very
concrete results. Often to be confronted with new challenges soon after, not least because
monetary and macroprudential policy are intertwined. And these challenges once again called
for policy innovation.
And maybe that is the essence of Schuman's vision: that the idea, the ideal of Europe was not
set as a goaltoachieve, but as a guide, to help us along the way. Step by step. One concrete
achievement after another. Improvising as we go along, but always in the same direction 
towards an integrated, solidary and peaceful Europe. The kind of Europe we will need in order
to tackle our future challenges.
Thank you.