Yves Mersch: Monetary policy in the euro area - scope, principles and
limits
Keynote speech by Mr Yves Mersch, Member of the Executive Board of the European
Central Bank, at the Natixis Meeting of Chief Economists, Paris, 23 June 2016.
* * *
Ladies and gentlemen,
The past few years, not to speak of present days, have been challenging ones for central
banks worldwide, and the euro area has been no exception. The ECB's monetary policy
decisions have come under greater scrutiny than ever before. Some commentators have
argued that the ECB does not have sufficient tools to counter deflationary pressures in the
euro area. Others contend that by using a wider range of instruments than in normal times,
the ECB has exceeded its remit.
Neither view is correct. Our Statute allows us to use a wide range of tools to meet our
mandate, and those tools are sufficient for that purpose.
But it is correct that there are limits on how far monetary policy can go. The ECB cannot, will
not, and need not exceed these limits. Our framework requires that unconventional tools are
used for no longer than necessary, and no more intensively than necessary. Within these
limits we independently decide on how best to comply with our price stability mandate.
Today, all major central banks have clear price stability mandates and can discharge them
with a large measure of independence. In the ECB's case, our price stability mandate is
enshrined in the Treaty,1 and we have been given "instrument" independence in how we
carry it out. We cannot decide whether we achieve our objective - we have to obey the law -
but we can decide how we do so.
This position has been confirmed by the European Court of Justice, which ruled that the ECB
can deploy any available instrument which is explicitly mentioned in the Statute to ensure
price stability. But the discretion we have over how we use our instruments, though wide, is
not unlimited "whatever it takes" is qualified by "within our mandate". Independence must not
be confused with arbitrariness.
The Treaties also set out a number of restrictions and principles that guide our monetary
policy. There are three in particular that stand out.
First is the prohibition on monetary financing laid down in Article 123, which prevents the
central bank from taking actions which would directly finance government spending.
We are prohibited from monetary financing for good reasons. If a central bank systematically
finances government budgets, it can fall prey to so-called "fiscal dominance" and fail its price
stability mandate. That is because, when inflation starts to rise, the central bank is in a
loselose situation: it can either continue financing the deficit and risk overshooting its objective, or
it can refuse to finance the deficit and risk a deflationary government default. But if the
central bank is ex ante forbidden by law from monetary financing, the incentives are stronger
for governments to run sound fiscal policies in the first place - and the independence of the
central bank is preserved. "Monetary dominance" prevails over "fiscal dominance". Fiscal
soundness is an essential feature of a monetary union with a single monetary policy and
national fiscal policies are necessary even if we were to achieve a fiscal union.
What is more - and this is specific to the euro area - monetary financing could imply a
redistribution of wealth among Member States, thus undermining the spirit of the "no bailout
clause" (Art. 125 TFEU). If the central bank were to facilitate a regime of unsound fiscal
policies and inflationary government deficits, it would inevitably expose itself to losses -
either real losses through the inflation tax, or nominal losses through a reduction in the
principal amounts it was owed. That would be tantamount to deliberate fiscal redistribution
between different sets of taxpayers via the central bank's balance sheet, which is not
permissible in a monetary union that is not a fiscal union. In other words, the prohibition of
monetary financing is the monetary counterpart of the "no bailout clause".
Second are the principles of judicial control: principle of conferral and principle of
proportionality laid down in Article 5, which requires that our actions are limited to what is
essential to achieve the objectives of the Treaties. Specifically, this means that our measures
need to be suitable, necessary and proportionate stricto sensu.2
For an instrument to be suitable, it needs to be able to address the respective risk to price
stability. For an instrument to be necessary, we must lack a viable alternative instrument. For
an instrument to be proportionate stricto sensu, its expected benefits should outweigh its
costs.
Third is the requirement to act according to the principle of an open market economy
favouring an efficient allocation of resources.3
All monetary policy measures have allocative and distributive effects. Cutting interest rates,
for example, has a redistributive impact on savers and borrowers, since it encourages
borrowing and discourages saving. Moreover, in certain situations - for instance a
panicinduced freeze in interbank markets - central bank intermediation may be critical to restore
market functioning and support an efficient allocation of resources. But this must always be
embedded in the understanding, which underpins the Treaty, that general markets distribute
resources more efficiently than public authorities, and hence central bank actions should not
blunt price signals or overwhelm market forces. Indeed, central banks should be marginal
actors, steering marginal decisions, not resource allocation mechanisms. That has to be
reflected in the design and implementation of our monetary policy tools.
In the pre-crisis period, when we used conventional measures, i.e. interest rate policy,
nobody had doubts that it was straightforward for us to respect these three operating
principles set out in the Treaty:
• By mainly implementing our policy through refinancing operations with commercial
banks, we were not accused of monetary financing.
• Our track record shows that raising and lowering rates was effective to maintain
price stability.
• And though all monetary policy, including interest rate policy, has allocative and
distributive effects, those effects were contained and predictable.
Our recent monetary policy measures respect the law
Since the onset of the crisis, however, we have had to adopt new, unconventional tools to
fulfil our mandate - and this has naturally brought the question of the scope and limits of
monetary policy more to the fore. Clearly, restricting ourselves only to the instruments used
in normal times would have been a breach of our mandate. It could have had disastrous
consequences for the euro area economy, and threatened our ability to achieve price
stability. But that does not imply the reverse - i.e. that every conceivable tool would have
been justified.
In line with our mandate, we have used a broad range of our instrument independence to
confront downside risks to inflation and achieve price stability. But equally, we have deployed
only tools that are in line with our legal framework. And that has been possible because we
have specifically designed our instruments so as not to exceed the three limits I outlined.
Take our asset purchase programme (APP) - which includes both public and private sector
bonds - as an example.
First, the APP respects the prohibition on monetary financing, since we have placed a
number of safeguards on our interventions.
We do not buy government bonds in the primary market, which is explicitly forbidden under
Article 123. And neither do we act in the secondary market in a way which could be
perceived as equivalent to acting in the primary market. The Eurosystem has put in place a
blackout period, and so does not buy in periods around the date of a new issuance.
Purchases are also subject to an issue share limit and an issuer limit. These limits ensure
that we would not constitute a blocking minority for collective action clauses if such clauses
were ever triggered. The European Court of Justice explicitly highlighted these limits when
deciding upon the lawfulness of our actions.
Second, it is proportionate, in the sense that it is both necessary and suitable to secure our
price stability objective.
As short-term interest rates move closer to their effective lower bound, it inevitably becomes
harder for central banks to steer the economy by means of conventional policy. So if inflation
is too low for too long - as is the risk in the euro area today - other tools become necessary.
Two years ago, the Governing Council introduced several non-standard measures to unclog
the transmission mechanism and avoid a credit crunch. We coined these measures "credit
easing package".
In January last year, we finally opted for large-scale asset purchases when faced with a
period of weak growth, when already low inflation rates were falling further and we saw risks
of inflation expectations destabilising. Like our previous measures, these purchases belong
to the category of credit easing.
To fulfil our mandate we need to make use of all instruments at our disposal. The APP is a
suitable tool because it acts directly on financing costs in the real economy. Rather than
attempting to boost the economy only through the short end of the curve, it directly lowers
yields at longer maturities, decreasing them by compressing the term premium, which in turn
influences the cost of credit for firms and households.
Third, we have designed the programme to limit distortions in relative prices which might
have unwanted allocative and distributional consequences.
With our government bond purchases we "mirror the market", which means that our
interventions are spread across issuers from the various euro area countries on the basis of
the ECB's capital key. Together with the issuer limits, this ensures breathing space within
and across markets for efficient price discovery. Indeed, even though yields are very low for
certain sovereign issuers, issuers have been able to place new securities in the market in
large volumes, which suggests that liquidity has not been materially affected by our actions.
Thus the most difficult part of our programme is our corporate bond purchases, since they
extend into less liquid markets and increase the risk of distortions in relative prices - in
particular between larger and smaller firms. But our activities cannot be evaluated in
separation; they must be judged in a holistic manner. Indeed, up to now the decline in bank
lending rates for small loans to euro area companies - which are mainly for small and
medium-sized enterprises (SMEs) - has been stronger than for large loans to bigger
companies. This suggests that bank lending conditions have improved disproportionately for
euro area SMEs since the announcement of our credit easing measures two years ago. As a
result, fewer SMEs are reporting that credit has been a limiting factor for their businesses.
This should only continue as our measures are fully rolled out and reach their maximum
impact. In other words, the APP, coupled with our other credit easing measures, has reduced
distortions caused by market fragmentation in the euro area.
Still, we know that the longer unconventional policy lasts, the greater the risk of distortions
appearing and diminishing its effectiveness over time. The principle of proportionality also
implies that we should only use such measures for as short a time as is necessary to fulfil
our mandate. That is why, when the economy improves and inflation returns to our objective,
we will have to reassess, adjust and ultimately phase out our purchase programmes and
other non-standard measures.
But the surest way to reach that point is to stay true to the course we are on now. If we were
to change speed or direction too soon, it would only set back the recovery of inflation and
delay the day that interest rate normalisation can happen. We will decide upon this in full
independence, in the interests of price stability, impervious to the wishes of any interest
group with any partial agenda.
Other policies can support the speed with which inflation returns to 2%
Can other policies help in this endeavour?
In the inflationary days of the 1970s, some central bankers were so hesitant about the scope
of their responsibility that they let price stability depend on others. For example, in the late
1970s the then Fed Chairman reported to the FOMC that "inflation is going to be left to the
Federal Reserve and that's going to be bad news. An effective program to reduce the rate of
inflation has to extend beyond monetary policy and needs to be complemented by programs
designed to enhance competition and to correct structural problems".4
But central banks have come a long way over the past half century. Today central banks take
ownership of their mandates and we do not depend on others. For example, if we were to run
into headwinds created by other policies, such as necessary fiscal consolidation, we could
increase our policy stimulus to compensate. But if other policies undermined the
effectiveness of our policy by disrupting or slowing down the monetary transmission
mechanism, responding to that scenario would be more difficult. In such a situation we can
only repeat that the support of other policies would speed up the return of inflation to 2%.
But this must not be seen as a call for an ex ante policy mix with a monetisation of public
debt or mutualisation of debt via Eurobonds under the present Treaty. This would mean
giving up monetary dominance.
Rather, economic and institutional policies can help accelerate the impact of our measures.
Structural reforms can reduce the transmission lag of our policy, since a more flexible, more
responsive economy is likely to transmit monetary impulses faster. And institutional reforms
can reduce uncertainty about the future setup of the euro area, which weighs on
expectations and holds back investment. Indeed, as we can see increasingly in Europe
today, strengthening confidence in the future trajectory of our Union is perhaps the most
decisive contribution we could make to growth.
Conclusion
Let me conclude.
The Eurosystem has broad discretion over the tools it can use to deliver its primary objective
of price stability. That objective guides the decision on which tools to use, and when to use
them, and defines the boundaries set out in our legal framework.
The use of additional tools in recent times reflects the ECB's commitment to delivering its
mandate. Such tools have been suitable to achieve our objectives and have been necessary
to combat deflationary headwinds.
Still, we are aware that - while justified - our latest non-standard measures are on a
significant scale. This is why our non-standard measures cannot last forever. They are
defined as unconventional and not designed for the long term. The goal of these measures is
that they make themselves redundant.