Jürgen Stark: Economic prospects and the role of monetary policy in the
current situation
Speech by Mr Jürgen Stark, Member of the Executive Board of the European Central Bank,
at the 5. Deutsch-Luxemburgische Wirtschaftskonferenz, Luxembourg, 9 March 2009.
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Ladies and Gentlemen,
Since the second half of 2008, we have witnessed the deepest economic downturn since
World War II and the fastest deceleration in inflation since the launch of the euro. We have
confronted this situation with unprecedented decisions. Unprecedented has been the
magnitude and size of interest rate cuts. Since October 2008, we have reduced key ECB
interest rates by 275 basis points. Unprecedented has been the scope of liquidity support we
offer to the financial system. But central banks alone are not in a position to resolve the
current financial crisis. Policy makers need to prevent a further deterioration in economic and
financial conditions. To this end, resolute action is needed to restructure, recapitalise and
consolidate the banking system.
To be realistic, the year 2009 will be a very difficult year. 2009 will be the year of adjustments
in the balance sheets of banks, firms and private households. These adjustments should lay
the foundations for economic conditions to eventually stabilise and improve.
Let me now elaborate in greater detail on where we stand in terms of economic and
monetary developments in the euro area and how this has affected the conduct of monetary
policy. I will subsequently talk about how we have adjusted our refinancing operations in
response to the financial crisis. Finally, I will briefly discuss challenges in the resolution of the
crisis.
Economic prospects
a. Global economic situation
Let me start with the economic outlook. The world economy is currently undergoing its
deepest downturn since the second World War. The crisis started in summer 2007, as losses
in the US sub-prime mortgage market, a relatively small segment of the US housing markets,
triggered the ongoing financial turmoil. However, its impact on the global economy remained
relatively limited until the summer of 2008.
However, after the collapse of Lehman Brothers last September, the tensions in global
financial markets escalated to a full-blown financial crisis and thereafter turned into a global
economic crisis. The severe global economic downturn has now become more synchronised.
The collapse in global trade has amplified the adverse impact from the financial turmoil and
caused emerging market prospects to deteriorate drastically. In advanced economies, falling
house prices, tumbling financial markets, collapsed household and business confidence, and
the resulting need to restructure consumers' and firms' balance sheets have been curbing
private consumption and investment. In emerging economies, nosediving global trade and
the unwinding of both internal and external imbalances accrued in past years have led to a
sharp decline or even negative GDP growth rates.
According to most economic forecasts, the weak growth period is expected to last for some
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time. For example, the IMFF projects that the world GDP growth would decelerate to only 1⁄2
% in 2009 measured in terms of purchasing power parity and even to turn negative when
measured in terms of market exchange rates. For advanced countries this means a negative
annual growth rate of -2% in 2009. For emerging economies the growth is projected to
remain positive, although the 3.3% growth projection is just half of the pace recorded in
2008.
While it is expected that the world economy will recover in 2010, risks surrounding the
outlook are on the downside as the depth and length of the global economic downturn will
crucially depend on the evolution of the financial crisis.
The inflation outlook has also changed significantly. Global inflationary pressures are quickly
diminishing. In the short term, this is mainly due to effects from lower commodity prices, but
over time, weaker labour market conditions and sluggish global demand increasingly play a
role.
b. Euro area activity
Let me now come to the euro area. Economic activity has not been sheltered from the
negative impact of the global financial crisis. We had seen already a moderation in the
underlying momentum of euro area economic growth before the crisis got worse. This
slowdown reflected the dampening effects from sharp increases in commodity prices before
the summer 2008 and the ongoing correction in the housing market in some euro area
countries.
As a result of all these factors, euro area activity declined markedly in the second half of
2008. After falling moderately in the second and third quarters of 2008, euro area GDP
growth contracted very sharply in the fourth quarter of the year, decreasing 1.5% quarter on
quarter. This reflected not only a decrease in foreign demand for euro area exports but
domestic demand was also adversely affected by domestic factors, notably very low
confidence and tight financing conditions. Annual growth in 2008, at 0.8%, was the weakest
rate since the early 1990s.
Indicators for the first months of this year suggest a further large contraction in activity in
early 2009. Consumer and business sentiment worsened further, falling to new all-time lows
in February. Moreover, labour markets have deteriorated which does not bode well for
consumer spending. In this context, let me stress that we in the ECB Governing Council
anticipated in our interest rate decisions that there will be bad news to come for the first
quarter of 2009, as we take our decisions in a forward looking manner. Once these
expectations of further weakness in growth are confirmed by official data, we will not to take
it into account again - there is no double counting!
Looking ahead, we expect a protracted period of further weakness in euro area activity. We
have to face the truth that 2009 will be a very difficult year. It will be a year of balance sheet
adjustments across banks, non-financial companies and private households. This could be a
further drag on investment and consumer spending, already negatively affected by very low
global demand, tight financing conditions and, in the case of private consumption, a further
deterioration in labour markets. However, these corrections are inevitable as they lay the
foundation of the gradual recovery. This is also reflected in the March 2009 ECB staff
macroeconomic projections. The expected negative or very low annual GDP growth in 2009
and 2010 somehow masks these developments as it is affected by negative carry-over
effects of the previous year. Looking beyond the annual growth numbers, the underlying
quarterly profile embodies expectations of increasingly positive quarterly rates of growth in
real GDP over the course of 2010.
Underlying this outlook is the expectation of a gradual improvement of the external
environment and a normalisation in financial markets, reflecting the extensive policy
measures that have been introduced to restore the functioning of the financial system, both
inside and outside the euro area. This together with low inflation rates which strengthen real
incomes and the strong fiscal and monetary stimulus should support the gradual recovery in
euro area activity.
In our view, the economic outlook remains surrounded by uncertainty. The risks to economic
growth appear now to be more balanced. On the one hand, there may be stronger than
anticipated positive effects, also on confidence, stemming from the extensive
macroeconomic stimulus under way and reflecting other policy measures taken. On the other
hand, concerns relate mainly to the potential for the turmoil in financial markets to have a
stronger impact on the real economy, as well as to the emergence and intensification of
protectionist pressures and to possible adverse developments in the world economy
stemming from a disorderly correction of global imbalances.
c. Euro area price developments
Let me turn to price developments. Inflation in the euro area has declined rapidly since it
reached its highest level in over a decade in the summer of last year. According to Eurostat's
flash estimate, euro area annual HICP inflation was 1.2% in February 2009, well below the
rate of 4.0% registered in July 2008. This decline primarily reflects the marked fall in global
commodity prices, and in particular oil prices, over this period, owing mainly to weak global
demand. The fall in commodity prices has also contributed to a significant diminishing of
supply chain pressures from very high levels as signalled by strong falls in survey measures
on price setting indicators of companies and substantial declines in producer prices at early
production stages.
Looking ahead, HICP inflation is expected to fall further in the coming months. This mainly
reflects a rather technical effect which is called "base effect". Base effects are important
when looking at developments in annual inflation rates, i.e. comparing the price level now
with the one registered a year ago. The increases in energy and food prices, which led to the
extended inflation hump until mid-last year, will subsequently drop out of the year-on-year
comparison in the coming months. These base effects will exert significant downward
pressure on overall inflation and there is a high likelihood that in this process of ongoing
disinflation annual HICP inflation in the euro area will temporarily turn negative in the middle
of 2009. It also cannot be excluded that we will see in some euro area countries negative
inflation rates for a more extended period of time.
However, this will mark most probably only a trough in inflation. The same factors pushing
down inflation in the first half of 2009, namely base effects related to volatile oil and food
prices, will subsequently unwind and actually put upward pressure on prices, contributing to
rising inflation rates over the course of the second half of 2009. Overall, the ongoing
disinflation process in the euro area is expected to imply sharp fluctuations in HICP inflation
rates during 2009 as also foreseen by the ECB staff projections. For 2010, the ECB staff
project HICP inflation at moderate rates.
Let me emphasise that sharp fluctuations in annual inflation rates or the temporary
emergence of negative inflation rates is a normal concomitant of any disinflation process,
which by its very nature is temporary and thus should not be confused with another "d"-word,
namely deflation. From a conceptual point of view, deflation is a completely different state. A
deflationary process is a persistent, broad-based and self-sustaining decline in the overall
price level. It is reinforced by the anticipation that prices will decline further in the future. As a
consequence, inflation expectations become unanchored and negative, with adverse effects
on investment and consumption.
By contrast, disinflation, which is linked to transitory movements in relative prices, is per se a
welcome development because it helps sustain real incomes, provided that medium-term
inflation expectations remain well anchored at levels consistent with price stability. To the
extent that this is the case, short-term volatility in annual inflation rates, including negative
inflation rates, is not relevant from the medium-term perspective of monetary policy. We
expect that price stability is maintained at the medium-term. Moreover, available information
indicates that medium-term inflation expectations in the euro area are solidly anchored at
levels consistent with the aim of the Governing Council of keeping inflation at rate of below,
but close to, 2% over the medium term. Such a firm anchoring represents the strongest and
most reassuring safeguard against any risk of a downward spiral of inflation and inflation
expectations. The fact that we have a clear mandate and a clear definition of price stability is
helpful in anchoring inflation expectations.
As in the case of growth, a considerable degree of uncertainty surrounds the inflation
projections of the ECB staff. Risks to these projections are broadly balanced. They relate in
particular to the risks to the outlook for economic activity as well as to risks to commodity
prices.
d. Monetary and financing conditions
Latest money and credit data support the view that inflationary pressures have been
diminishing. Broad money growth decelerated in 2008, increasingly so at the turn of the year.
In particular, it brought headline M3 growth back to levels that reflect the underlying
monetary dynamics, which also decelerated.
The financial turmoil and its intensification in September 2008 had a substantial impact on
the behaviour of market participants and affected money and credit dynamics, leading to
higher volatility in money and credit aggregates. On the money side, this relates in particular
to marketable instruments, but also to the significant substitution that is taking place between
different categories of deposits included in M3. On the credit side, the flow of bank loans to
the private sector around the turn of the year was also rather volatile, partly reflecting a
possible turn-of-the year effect. But discounting this effect, latest credit developments
confirms the decline in the growth of bank credit to households and firms observed during
2008.
This shows how important it is to look through short-term developments when assessing the
underlying pace of monetary expansion and the associated indication for risks to price
stability.
Let me turn to the financing conditions in the euro area which have deteriorated further since
September 2008. With plummeting equity valuations and soaring credit spreads, the overall
cost of financing for euro area non-financial corporations has edged upwards. At the same
time, bank lending rates have declined. In fact, it seems that the substantial past reduction in
the key ECB interest rates is increasingly being passed through to bank lending rates,
indicating that, despite the tensions in financial markets, the transmission mechanism of
monetary policy is not significantly impaired in the euro area.
Monetary policy
Let me now turn to the second part of my speech, namely the role of monetary policy in the
current situation.
The financial crisis has contributed to a pace in disinflation and economic deceleration which
has been unprecedented. This has required us taking unprecedented decisions to contain
adverse spillover effects of financial market tensions on the real economy and thereby to
maintain inflation over the medium term in line with price stability.
In a coordinated move, the ECB and other major central banks announced reductions in their
policy interest rates on 8 October 2008. Overall, since October 2008, we lowered the key
ECB interest rates by 275 basis points. The overnight money market rates fell even more
steeply over this period, as the ECB significantly enlarged its liquidity provision to euro area
banks. Since October last year we have provided the banking sector with unlimited funds at
maturities up to six months, against an expanded range of eligible collateral. These decisions
have been taken in a timely and decisive manner, in a context characterised by an
exceptionally high level of uncertainty.
To better understand the scale of our interventions in the interbank money market, one
needs to appreciate its importance in the implementation and transmission of monetary
policy. Money market interest rates, especially of short maturities mark the starting point in
the transmission of monetary policy. They determine the marginal costs of refinancing of the
banking sector and thereby act through the bank lending channel. Money market interest
rates are a key factor in determining the entire yield curve and thereby are crucial for the
expectations channel of monetary transmission. Of course, longer-term interest rates and
bank lending rates cannot be directly controlled by the central bank, but expectations of
short-term money market rates are key in determining them.
Contributing to the functioning of the money market and preventing a liquidity crunch
therefore has been crucial to forestall a breakdown of the transmission of monetary policy
and a systemic crisis. As a consequence of our measures, the Eurosystem's consolidated
balance sheet has grown by two thirds from summer 2007 until most recently, or by 6% of
euro area nominal GDP. To put these numbers into perspective, the size of our balance
sheet has grown from 13% of euro area nominal GDP in 2007 to over 20% most recently. By
providing unlimited funds in our refinancing operations we have ensured that banks facing
difficulties raising funds in the market are always able to fulfil their liquidity needs.
But we need to be realistic about what we, as a central bank, can achieve. In my view, we
cannot expect to see the money market functioning the way it did before August 2007. What
is certainly encouraging is that recently the volumes allotted in our refinancing operations
have come down slightly. The same is true for the number of banks participating in these
operations. Spreads between secured and unsecured interest rates at term maturity have
gone down somewhat. But they have remained high. The turnover in unsecured interbank
lending, especially at longer maturities, still remains low. To be clear: The problem is not a
lack of liquidity in the market. It is the lack of trust among the banks themselves. Unless trust
in the solvency of banks is re-established, there is hardly any chance that conditions in the
money market will normalise.
As already mentioned, financing conditions have not eased exactly in line with key ECB
interest rates. So will key ECB interest rates have to be cut to even lower levels? In principle,
even after last Thursday's decision the ECB could still contribute to easing credit conditions
by cutting its key interest rates further. But this will not fundamentally solve the problems that
have caused the financial crisis. The contrary could be the case. If maintained for an
extended period of time, too low or very low interest rates might in fact aggravate them. They
have the potential to weaken the incentives for banks to clean up their balance sheet of
troubled assets and monitor their credit risk carefully. This in turn may reinforce the very
problems that currently impair the functioning of the financial system. Too low interest rates
tend to foster lending to unprofitable business. This would harm the growth potential of the
economy and thereby prepare the ground for anaemic growth. Or, as in the past, it could lay
the foundations for another asset price bubble. Finally, very low interest rates hamper the
functioning of the money market: The lower interest rates in the money market, the lower the
incentive of banks to trade funds in the market rather than depositing them safely, at the
same low return, with the central bank.
So, as we have started to operate at very low interest rates, are we running out of
ammunition to ease monetary conditions further if warranted? Do we need to take more
nonstandard measures?
Let me emphasise that what we have implemented so far has already been rather
unconventional. But in considering any additional action to improve the functioning of the
financial system and transmission of monetary policy we need to be mindful of our
responsibilities and our mandate - i.e. to be conscious of what monetary policy can do and,
even more importantly, what it cannot, and consequently should not do.
Central bank measures aimed at easing credit conditions have not been met with undivided
enthusiasm. Commentators have worried about a host of issues. Will the expansion of
central bank balance sheets ultimately lead to inflation? As central banks are seen as
switching attention from implementing monetary policy by steering short-term interest rates to
targeting the composition and size of their balance sheets, have they lost their instrument?
Have they become intransparent and unpredictable? With the measures put in place, how
are central banks going to preserve their financial and political independence which has been
so hard to earn? Under what conditions and when are central banks going to unwind these
measures?
I can assure you, we have not lost sight of the principles that have successfully guided us in
the past. The measures that we have taken and any additional measures we might
implement remain strictly consistent with our responsibilities. Accordingly they meet a whole
range of criteria and they will continue to do so.
Any additional measures need to be consistent with our mandate and our principles.
Consequently, they can only be taken with the view to pursue price stability and to contribute
to the preservation of financial stability. Pursuant to this objective and the Treaty
requirements the measures must be compliant with the prohibition of monetary financing. In
addition, the scope of such measures is limited by the need to contain the Eurosystems risk
exposure so as to safeguard its financial independence, as otherwise the ECB will end up
jeopardising its credibility. Furthermore, as conditions in the financial system will eventually
improve and in line with our assessment of risks to price stability these measures will be
unwound. Accordingly, and finally, bearing also in mind that the health of the financial system
cannot be made the ECB's responsibility, one needs to be careful not to blur the
responsibility of monetary and fiscal authorities in the euro area.
Of course, we will do whatever we judge to be necessary and appropriate to maintain price
stability and contribute to the preservation of financial stability. But we will strictly adhere to
these principles.
In considering further easing measures, these principles have obvious implications. Central
banks can alleviate liquidity risks. But they cannot address the perceived solvency problems
that impair the financial system. One could conceive measures to ease credit conditions by
taking over some of the credit risk on commercial paper that banks currently hold. The ECB
has already been accepting corporate loans as part of collateral in its regular liquidity
operations. By operating through the banking sector, this has significantly contributed to
providing funding to non-financial corporations - and thereby an easing of credit conditions.
Buying corporate debt outright would circumvent the banking sector.
We have a responsibility to keep the Eurosystem financially sound. This concern puts a
break on how much further we can expand our balance sheet.
How to solve the crisis?
Clearly, the challenges for resolving the current crisis remain tremendous. There is no
panacea. We have made our contribution by making sure that longer-term inflation
expectations have remained anchored in line with price stability and by preventing a liquidity
crunch. It remains our responsibility to continue to do so. But one cannot rely solely on
central bank policies to address all the consequences of the financial crisis and its fall-out on
the economy.
Resolute action is needed to restructure, consolidate and recapitalise the banking system.
Specifically, action is needed to help banks support their balance sheet so as to sustain an
adequate flow of credit to the non-financial sector.
Since last autumn, governments have provided or pledged a substantial amount in
guarantees for new debt issuance by banks. In addition, they have recapitalised a number of
financial institutions. The commitments to provide support are already substantial. But it will
take time for the measures to be completely implemented and to show their full effects. In
case these measures prove to be insufficient, they need to be complemented by further
actions to address problems on the asset side of banks' balance sheets.
To be successful in resolving the financial crisis the asset support schemes need to meet a
whole range of objectives. From the central bank perspective the overwhelming objective is
to safeguard financial stability and restore the flow of credit from banks to the private sector.
In addition, the measures taken will need to be implemented in a way so as to maintain a
level playing field in the EU financial market and minimising the burden to public finances.
In line with these objectives, the Eurosystem has issued a set of guiding principles for the
design and implementation of asset support schemes to address the most critical issues.
Apart from guidance on the types of assets and institutions that would be eligible to support,
these guiding principles call for an adequate degree of risk sharing as a necessary element
to limit the cost to the government, to provide the right incentives to the participating
institutions and to maintain a level playing field across these institutions. They also mention
that schemes with well-defined exit strategies should be favoured and that conditionality may
be attached to such schemes.
Conclusion
Let me conclude. We face unprecedented challenges. At the ECB we have demonstrated a
willingness and capacity to react rapidly to exceptional circumstances. We have cut interest
rates sharply to forestall the emergence of downside risks to price stability. We have
provided unlimited liquidity support to the banking system so as ensure that liquidity risk does
not lead to a systemic crisis. But, ultimately, we alone as central bankers cannot resolve the
current financial crisis. The onus is now on governments, supervisory and regulatory
authorities, and the financial industry itself, to cooperate to act resolutely to restructure,
recapitalise and consolidate the banking system. Such government measures are under way.
On our side we will continue to do whatever we judge to be necessary and appropriate to
maintain price stability and contribute to financial stability. And in doing so we will stick to the
principles that have served us well in the pursuit of price stability. We will safeguard our
financial independence. We will be transparent and accountable for our actions. Most
importantly, we will remain faithful to our mandate and provide an anchor of confidence and
stability in difficult times.