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On Phronesis and Price Stability

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'With phronesis - practical wisdom. That is how the Eurosystem operates,' said Klaas
Knot on 28 November, at the EuroS0 Group's 25" anniversary at the Banque de
France. He illustrated this with three examples: the ECB's balance sheet policy, the
change in the neutral interest rate (r*) and recent supply shocks.

Published: 28 November 2024

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BANQUE DE FRANC


Thank you, Edmond. And thank you for organising today's debate at the Banque de France -
this is such a grand setting.

Testimony to that is the splendid Galerie Dorée, where we will have dinner later this evening.
But even just walking in, you feel its historic importance.

Relief at the entrance showing the virtue 'phronesis'

Sources: Store Norske Leksikon and Wikipedia.

On the right side above the entrance on Rue Croix des Petits Champs, you can see a relief of
the virtue 'phronesis'.

It's a female figure holding a hand mirror while a snake curls around her arm. The mirror
symbolises the ability to see oneself as one truly is - which is a source of knowledge. And the
snake refers to wisdom.

In today's English, the Greek word 'phronesis' would be translated as 'prudence'. But that
doesn't fully do justice to its origin. Phronesis is not so much 'cautiousness', but more 'being
able to do the rational thing at a given time and place' -- or shorter: phronesis refers to
'practical wisdom'.

As such, I believe it is quite fitting that this virtue welcomes anyone who enters this building.
As a matter of fact, I think it wouldn't be out of place on every central bank building in the
euro area. Because that is how the Eurosystem operates throughout all the changes our
economies undergo: with phronesis, with practical wisdom.

Today, I would like to illustrate this with three examples: the balance sheet expansion at the
effective lower bound (ELB), the changes in r-star, and the recent supply shocks.

First - the balance sheet expansion.

I became Governor of the Dutch central bank almost fourteen years ago. At the time, the euro
area economy was just recovering from the global financial crisis (GFC). As it later turned out,
the GFC marked an important shift in the macroeconomic environment.

In particular, we had to deal with deflationary pressures. These followed from the GFC and the
sovereign debt crisis. But structural trends, such as globalisation, digitalisation, and
demographic changes, also played a role.

Like other central banks, the ECB had to respond to these events. To fight the crises and
support monetary transmission, the ECB intervened in financial markets by providing liquidity
and securing funding for banks.

The Eurosystem's monetary operations

Chart 2: Balance sheet expansion at the effective lower bound

7500 +
6500
5500 +
4500
3500 +
2500 +
1500
500

-500 4 A

07 09 11 13 15 17 19 21 23
Asset Purchases Other Net Assets
mame LTRO/TLTROs mas Regular Refinancing Operations

-- EONIA/ESTR

Source: DNB. Note: Monthly data. Left-hand side: Billions of Euro. Right-hand side: percentage points.

But in dealing with deflationary pressures, the ECB also ran into the challenges associated
with the effective lower bound. Easing the stance while conventional policy space was limited
required the implementation of new, unconventional tools, including large-scale quantitative
easing.

In hindsight, these policies were effective in staving off deflationary risks. What really helped,
of course, is that both the tools for stance and other tools for transmission generally worked in
the same direction: they eased financing conditions. But that does not mean that our toolkit
comes without side effects.

For instance, one implication of the new policies is that they blurred the separation principle.
This principle has been one of our guiding principles since the introduction of the euro. It
basically states there should be a strict distinction between the 'what' and the 'how' of
monetary policy - between formulating a monetary policy stance and creating liquidity, for
instance as the lender of last resort.

But the large-scale balance sheet expansion - particularly the quantitative easing
programmes of the past decade - made the 'how' an integral part of the 'what'. Liquidity
creation could now be directly linked to the way monetary policy was implemented.

Moreover, tools like the targeted longer-term refinancing operations and the pandemic
emergency purchase programme were naturally hybrid - they were explicitly designed both
to ease the policy stance and to stabilise markets and support monetary transmission.

Looking ahead, stabilisation tools will remain important elements of our toolkit. We might
need them again to contain market dysfunction and support monetary transmission.

If you would ask me whether, away from the ELB, a return to the separation principle is
desirable, I would say: yes, but in a different form.

As you know, our transmission tools have become more comprehensive: from traditional
lender of last resort to a range of operations, including market maker of last resort. And with
our new operational framework announced earlier this year, we will continue to operate with
ample liquidity conditions.

Having said this, going forward, I do see some scope for a separation principle 2.0 - one that is
no longer defined in terms of liquidity creation, but in terms of the purpose of a tool: steering
monetary conditions versus safeguarding a homogeneous transmission.

Distinguishing the monetary stance from safeguarding monetary transmission makes sense
because these operations may have to be implemented in opposite directions - like when the
ECB launched the transmission protection instrument (TP) at the same time it stopped net
purchases under the asset purchase programmes. And even if policies pull in the same
direction, we may - at some point - have to end one policy and continue the other.

For our toolkit, such a new separation principle would mean less scope for hybrid instruments,
outside of the ELB.

TPI, is a good example of separating stance and transmission. It has enabled us to tighten
policy decisively without unwarranted increases in sovereign spreads.

And so, I believe the ECB was exemplary in showing phronesis - practical wisdom - in dealing
with changing circumstances. When needed, new tools were developed to provide liquidity

and to ease monetary conditions. But going forward, we may want to separate instruments
that steer the stance from those that support transmission.

Let me now turn to my second example of phronesis: r-star, the neutral interest rate.

Of course, as an unobserved variable, r-star is subject to estimation and measurement
uncertainty. On top of this, monetary policy recently had to deal with large and, above all,
unprecedented shocks. These rendered our staff projections less precise. Additionally, the high
pace of monetary tightening created uncertainties about the speed of transmission to the real
economy.

Against this backdrop of heightened uncertainty, the ECB decided to follow a data-dependent
approach. In particular, interest rate decisions would be based on the Governing Council's
assessment of, one, the inflation outlook in light of the incoming economic and financial data,
two, the dynamics of underlying inflation, and three, the strength of monetary policy
transmission.

The result was a remarkably fast and, to date, relatively painless process of disinflation. As
such, monetary policy today is gradually winding down some of the restrictions, based on the
same data-dependent approach.

But r-star is not only an important, albeit noisy, benchmark for monetary policy - it can also
be informative for the monetary strategy.

Small increase in r* across a range of models

Chart 3: Natural rate of interest in the euro area

4
3

2

99 01 03 05 07 og 1 13 15 17 19 21 23

Sources: DNB and Federal Reserve Bank of New York. Note: Blue line shows mean across models, with the blue shaded area representing
© DNB the min-max range across models. Models included are Brand, Goy and Lemke (2021), Holston, Laubach and Williams (2023), Goy and
€ rr Iwasaki (2024) and Goy and Italianer (2024). Latest observations are 202304 for Holston, Laubach and Williams (2023) and 202492
otherwise.

Over the last two decades, we have clearly seen a decline in r-star. A vast body of literature
links this decline to lower productivity growth, higher risk aversion and safe asset scarcity, as
well as demographic changes. (See, among others, Rachel and Smith (2015) (7, Caballero et al.
(2017) (4, Mian et al. (2020) (7, Gourinchas et al. (2022) (7, Papetti (2021) (7 or a recent
speech by Isabel Schnabel (2024) (4 for on overview.)

Since the pandemic, though, things appear to have changed, at least somewhat. Eurosystem
estimates of r-star increased compared to pre-pandemic levels. The median estimate rose by
about half a percentage point (Brand et al., 2024 (%).

Higher r* driven by lower convenience yield and higher trend participation rate

Chart 4: Decomposition of the increase in r* since December 2019

15

GR Change trend productivity growth Change trend average hours worked

WChange in trend participation rate (Convenience yield

GBB 10n-growth, non-risk factor -- Cumulative change r*

Sources: DNB calculations. Note: Cumulated changes of the posterior median latent states. The model is an extension of Del Negro et al.
(2017, Brookings Papers) with the convenience yield being defined as the 10-year Bund OIS spread and the stochastic discount factor being

' ©ODNB aa further split into per capita trend growth and a non-growth component. Last observation 2024Q2.

According to DNB staff analysis - focusing for now on a single model - the increase in r-star
since 2019 could be attributed to two factors.

First, a decrease in the convenience yield. This is consistent with the general increase in euro
area government debt in recent years and an unwinding of the asset purchase portfolio. While
the former may not persist if the new fiscal framework is successful, the latter is likely to
persist for some time.

Second, an acceleration of the increase in the labour market participation rate. This creates a
one-off boost to trend growth - as such, it increases r-star.

But again, let me reiterate that these numbers are derived from a single model and should
therefore be interpreted with the usual grain of salt when we look at estimates of r-star.

Nevertheless, despite the recent up-tick in r-star, I think it is too early to speak of a trend
reversal in r-star. And so, the phronetic thing to do for monetary policy is to be prepared to deal
with future lower bound episodes.

So, to me, the most important part of the latest strategy review was acknowledging the ELB
and how to deal with it. As such, the review concluded that - and I quote: "when the economy is
close to the lower bound, this requires especially forceful or persistent monetary policy measures to
avoid negative deviations from the inflation target becoming entrenched". Unquote.

And still, the ink on the strategy review was still wet when the macro-economic situation
changed again, and we experienced a series of rather persistent supply shocks. And as a result,
inflation soared to historic heights.

Dear colleagues, after the separation principle and r-star, let me now turn to my third
illustration of phronesis: the response to recent negative supply shocks.

Specifically, I think we must ask ourselves: how persistent should monetary policy be ina
world with large supply shocks?

It is widely accepted that, in the face of cost-push shocks, fully stabilising prices leads to
inefficient variation in output. That is why the ECB looks at the medium-term - and as such
looks beyond temporary supply shocks.

The duration and magnitude of shocks are, however, unknown beforehand. Luckily, economic
research may provide some guidance. As such, it may be optimal for monetary policy to look
beyond temporary supply shocks as long as inflation expectations remain anchored (Beaudry
et al., 2022 (7), but to pivot aggressively once the risk of de-anchoring rises.

This research supports the policy reactions of the large central banks in recent years.

DNB QgdAaQg &

To the extent that these structural forces affect potential output, counteracting their
contractionary effects is largely ineffective. And, in terms of inflation, it may even backfire as
high inflation may become entrenched. So, in the face of rather persistent supply-side shocks,
monetary policy should focus on stabilising inflation.

Dear colleagues, I'm wrapping up.

I was invited here today to share some thoughts on what has changed in the conduct of
monetary policy in the eurozone.

Indeed, quite a bit has changed.

And all those changes followed changes in the macroeconomic situation. Changes that
required practical and rational responses.

I believe the ECB has shown a lot of phronesis in dealing with the economic shocks in recent
years. And I may hope that this age-old virtue continues to guide us in the years to come.

For as long as we have the euro, the Euro50 group has been a valuable forum to discuss the
monetary challenges that come with macroeconomic changes. This group is not called Euro25,
so may this continue to be a place of inspiration and debate for at least another 25 years.

Thank you.

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