Jürgen Stark: Monetary policy before, during and after the financial crisis
Speech by Mr Jürgen Stark, Member of the Executive Board of the European Central Bank,
University Tübingen, Tübingen, 9 November 2009.
* * *
1 Monetary policy before the financial crisis of 2007
Before I start with the discussion of the ECB's monetary policy before the financial crisis of
2007, let me briefly recall the key features of the ECB's monetary policy strategy. First of all,
in order to provide a yardstick against which the ECB can be held accountable, the
Governing Council, in line with its definition of price stability, aims to keep inflation rates
below, but close to, 2% over the medium term.
In addition, the two-pillar structure of our analytical framework plays a major role in assessing
the risks to price stability over the medium term. There are two pillars because it consists of
economic and monetary analysis. The economic analysis is especially suitable for detecting
short to medium-term risks to price stability. The monetary analysis plays a prominent role in
identifying inflationary trends over extended horizons. It takes into account the long-term
relationship between money and prices. This helps to ensure the medium-term orientation of
the ECB's monetary policy. In this sense, the monetary analysis serves as a means of
crosschecking the short to medium-term signals from the economic analysis from a medium to
longer-term perspective.
Keeping our strategy in mind, let me discuss the economic environment that prevailed before
the financial turmoil started in August 2007, for it is vital to understand the causes of the
financial crisis and, hence, the role of monetary policy in the run-up to the crisis.
If I were to characterise the years since the inception of the euro in 1999 until the start of the
financial tensions, from the perspective of an economist, with a few words, most observers
would probably agree that "globalisation" and "deregulation", as well as "technological and
financial innovation", are among the elements I should mention. In addition, "stock and
housing market bubble" and "global current account imbalances" would figure prominently
among those with a more negative connotation. Needless to say, this list is by no means
complete.
With the exception of the cyclical downturn following the bursting of what many observers
have called the "dot-com bubble" in 2000/01, the world economy had been enjoying a period
of robust growth since 1999. World trade had increased to unprecedented levels during that
period, and international economic and financial integration had deepened considerably.
At the same time, emerging economies, especially in Asia, endowed with the memory of
recent currency crises, had started to build up foreign exchange reserves, partly driven by
the desire to hedge against the volatility of international capital flows. What was necessary
for this accumulation of reserves were large and persistent current account surpluses, i.e.
these countries were consuming less than they actually produced in each year, while some
others, mainly advanced economies, were doing just the opposite. These latter countries had
been living beyond their means. In some of these advanced countries, the strong
consumption growth was driven mainly by increasing household indebtedness.
As this had continued unabated over the years, significant global imbalances developed and,
until late 2007, a strong global trend of increasing imbalances prevailed in full.
This period was also characterised by a widespread tendency of deregulation and the
emergence of financial innovations, which were insufficiently regulated. In fact, these trends
were closely connected to the strong forces of globalisation.
As one example of such innovations in the financial sector during that time, let me mention
securitisation. This concept, which had been known in the United States since the late
1970s, relates to the repackaging of assets that sit on financial institutions' balance sheets
into marketable slices, i.e. securities, with the aim of selling these new securities in financial
markets. This sale frees up capital in banks, which can then, in turn, increase their lending. A
glance on some US figures serves to illustrate the steep increase in securitisation over the
last few years before the turmoil. The outstanding amount of US asset-backed commercial
paper, which is only a fraction of the total of the assets generated through securitisation,
increased from around USD 500 billion in August 2004 to over USD 1.2 trillion just three
years later. Although total issuance of asset-backed securities by banks between January
2005 and August 2007 was more than seven times higher in the United States than in the
euro area, monthly issuance in the euro area still reached EUR22 billion, on average. This
shows that, although more pervasive in the United States, excess lending due to
insufficiently regulated securitisation activities also affected the euro area.
It is easy to recognise the huge benefits of securitisation for growth, but there are also
substantial downsides. The significant increases in sub-prime mortgage lending from 2005
onwards, for example, were only possible with the help of securitisation. I do not think that it
is too far-reaching to claim that much tighter financial market regulation is needed in order to
reap only the positive benefits of securitisation.
How are these developments connected with monetary policy, especially with monetary
policy in advanced economies?
My answer to this question is that the current financial crisis has shown that there are many
linkages indeed.
First of all, the dynamics of globalisation have certainly made the central banks' task of
analysing the inflation process more complicated. This may have caused potential output,
which is a crucial input for the economic analysis of risks to price stability, to have been
overestimated. In other words, some of the strong growth we had experienced in that period
may have been unsustainable in the first place.
Second, the build-up of global imbalances arguably contributed to a distortion in relative
asset prices, resulting in a systematic under-pricing of risk in financial markets. Indeed,
looking at financial market data from periods as recent as the first half of 2007, you will find
embedded credit risk premia, for example for unsecured interbank loans, that are very close
to zero and appear amazingly low. Yet central banks have to rely on functioning financial
markets, since they are essential for the transmission of monetary policy signals to the
economy.
Third, insufficient regulation for financial innovations, as in the case of securitisation, led to
the creation of whole asset classes, e.g. sub-prime mortgages, whose economic basis was
less than sound. This contributed to the build-up of substantial risks to financial stability, as
cash flows in these asset classes would be extremely vulnerable to stagnating or even
declining house prices.
Taking all this into account, it can probably be argued that central banks around the world
had, to differing degrees, contributed to fuelling asset price bubbles by keeping policy rates
at very low levels for a protracted period of time in an environment of robust economic
growth, ample global liquidity, continued low inflation rates and low default risks.
Before I turn to the renewed debate on whether or not central banks should address asset
price bubbles, I would like to say a few words about the monetary policy of the ECB, and the
central role of its monetary analysis in the pre-crisis period.
Indeed, the euro has been a remarkable success, and the ECB has delivered what it is
expected to deliver under its mandate, namely the maintenance of price stability in the euro
area. I think there is broad consensus as regards this observation. First of all, with inflation
averaging only slightly above 2%, the euro area has witnessed a decade of relative price
stability, despite a number of severe upside price shocks. In addition, medium and long-term
inflation expectations have, judging by all available measures, remained firmly anchored at
around 2%. Such anchoring reflects favourably on the smooth functioning of the ECB's
monetary policy and its high degree of credibility, which is based on the principles for sound
central banking.
Analysing risks to price stability using our two-pillar approach served us well during these
times. Let me give you some specific examples of the impact of signals from our monetary
analysis on our actions.
As you are aware, in the aftermath of the bursting of the dot-com bubble and faced with
receding inflationary pressures, the ECB lowered its policy rate to 2%. It was because of
signals from the monetary analysis that we stopped lowering rates still further.
In the same vein, when the ECB decided in late 2005 to start increasing its policy rates
again, it was mainly because our monetary analysis indicated upward risks to price stability.
At the time, the signals from the economic analysis were rather mixed, and I remember that
we were widely criticised for our decision. In retrospect, I would say this decision appears to
have been well-timed, given the strength of the economic upturn that followed from 2006
onwards.
Finally, using signals from the monetary analysis, we continually reminded market
participants during those times that risk premia in financial markets were extraordinarily low
and that the strong growth in credit aggregates implied future risks to financial stability. On
various occasions in 2006 and 2007, we voiced concerns and warned markets to prepare for
the unavoidable correction.
You all know what happened. The repricing of risks did indeed occur, although in a much
more dramatic way than anticipated. There was virtually nobody who foresaw a financial
crisis of such abruptness and swift progression, nor its severity. The complex interaction of
the factors that I outlined earlier had created enormous risks for financial stability.
2 Monetary policy in times of financial crisis
Let me now give you a detailed account of what have been - and continue to be - very
challenging times for the conduct of monetary policy. I will concentrate on the most important
cornerstones of the current financial crisis, from the perspective of a European central
banker, of course.
2.1 The start of the crisis: fine-tuning money markets
On 9 August 2007, short-term money markets rates such as the overnight rate suddenly
started to surge. The ECB was the first central bank in the world to react, and did so
immediately, calming the markets, first, with a technical announcement via the relevant
Reuters pages and, later in the course of the day, with the provision of unlimited central bank
liquidity with overnight maturity at the prevailing policy rate.
The demand of banks turned out to be extraordinarily strong, totalling EUR95 billion. Over
the next two days, further liquidity-providing fine-tuning operations were conducted, so that
tensions in short-term euro area money markets abated to some extent.
This series of fine-tuning operations turned out to be the starting point of the first phase of
policy responses to the financial crisis, a phase that lasted until September 2008. During that
time, the ECB addressed tensions in euro area money markets within its operational
framework, mainly by "frontloading" credit extended via its main refinancing operations within
the reserve maintenance period, while at the same time keeping the overall supply of central
bank liquidity unchanged. Put simply, "frontloading" means that the ECB provided higher
amounts of credit at the beginning and lesser amounts of credit at the end of each relevant
period, the reserve maintenance period, instead of always extending the same amounts of
credit in each operation.
Further important measures that fall into the early phases of the crisis were the lengthening
of the average maturity of our liquidity provision by conducting supplementary refinancing
operations with maturities of three and six months, the provision of US dollar liquidity against
euro-denominated collateral, on the basis of a swap agreement with the US Federal Reserve
System, and the conduct of a two-week full-allotment tender in the penultimate main
refinancing operation of 2007 in order to address especially elevated funding concerns of
banks over the year-end of 2007.
Until the end of August 2008, all these measures - which were taken within the Eurosystem's
operational framework - proved broadly sufficient to align short-term money market rates
with our policy rate, although the volatility in money market rates was higher than before
August 2007 and money market spreads at longer maturities remained elevated.
Overall, during that time, the monetary policy implementation framework of the ECB proved
extremely robust and suitable to address the challenges. In particular, our measures allowed
the determination of the monetary policy stance to be kept separate from the way it is
implemented, i.e. the ECB's management of the liquidity in the euro area money market. The
interest rate hike of July 2008 is an example of the application of the separation principle. We
took this step at the time, which is fully in line with our primary objective of maintaining price
stability, to prevent second-round effects, with a view to avoiding the dis-anchoring of
inflation expectations, even in times of money market tensions.
2.2 Extraordinary times and measures: extraordinary rate cuts and enhanced
credit support
In September 2008, conditions in financial markets worsened dramatically. The bankruptcy of
Lehman Brothers led to the emergence of a full-fledged financial crisis and this, in turn, was
accompanied by a rapid deterioration of economic conditions in most major economies of the
world.
The ECB reacted decisively and swiftly on two fronts. First, consistent with its mandate of
maintaining price stability over the medium term and, specifically, in view of rapidly receding
inflationary pressures, the policy rate was cut by 325 basis points and now stands at 1%.
Second, the ECB engaged in what we refer to as enhanced credit support and I will
elaborate a bit more on this in what follows. After the bankruptcy of Lehman Brothers,
interbank money markets simply stopped working. Banks did not trust each other any longer,
since nobody was sure just how risky it really was to lend to another bank. In terms of
economic theory, one could say that information asymmetries had become too large, with the
result of a market breakdown. And economic theory also tells us that a market breakdown is
justification for public sector intervention.
Two of the main functions of interbank money markets are the intermediation of liquidity
shocks and the provision of short term funding for financial institutions. In other words, the
financial sector cannot work without these markets, cannot fulfil its role of supplying the
economy with credit. Consequently, in the case of the euro area, these functions had to be
taken over by the ECB. To achieve this, a number of actions were taken.
The ECB switched to fixed-rate tenders with full allotment in all liquidity-providing operations
in October 2008. In practical terms, this was a change in the way the ECB "sells" its loans to
the financial sector, away from a competitive auction to a fixed-price offer without limitations
on the quantity. This change guaranteed banks access to as much central bank liquidity as
they needed, provided they possessed sufficient eligible collateral. The term collateral refers
to an asset that the financial institution temporarily deposits with the ECB in exchange for the
loan it receives. If the institution pays back its loan, the asset is returned. Indeed, all loans
that financial institutions receive from the ECB are fully collateralised and, hence, take the
form of secured lending.
In connection with this change, as a further safeguard, the already relatively broad set of
eligible collateral was expanded further, taking into account market developments and
making sure that collateral would not be the limiting factor for banks. In general, the ECB
accepts only high-quality assets as collateral, such as government bonds, covered bonds
and some asset-backed securities, all of which need to posses a certain minimum rating.
Furthermore, we discount the value of the collateral banks post with the ECB, according to
the risk of the asset, in order to protect the ECB from the default risk of the borrowing
financial institution.
In addition, the maturity spectrum at which the ECB offered refinancing operations was
broadened, with operations covering the full length of the maintenance period and, in May
2009, one-year longer term refinancing operations being added. In enhancing the "menu" of
maturities at which banks can obtain liquidity, the ECB supported the financial sector further
as it made the refinancing of banks up to a certain horizon more predictable and, at the same
time, less costly.
Finally, also in May 2009, we added a covered bond purchase programme. Covered bonds,
known as "Pfandbriefe" in Germany, are long-term debt securities that are issued by banks to
refinance loans to the private and public sector, often in connection with real estate
transactions. Although covered bonds are low-risk assets and are tightly regulated via
specific laws, markets for these bonds were nevertheless strongly affected by the
intensification of the financial crisis in September 2008. Supporting these markets, therefore,
amounted to bolstering the long-term refinancing options of the financial sector, and to
helping to overcome fundamentally not justified liquidity problems in an otherwise sound
asset class.
As you will certainly have noticed, all these measures were designed specifically to support
the vital role financial markets play as intermediaries with respect to providing credit to the
economy. In the euro area, this role is mainly assumed by banks. The enhanced credit
support, therefore, is aimed mainly at supporting banks in the fulfilment of their role.
The importance of bank financing for the euro area economy also helps to explain the
differences between the tools employed by the US Federal Reserve and the ECB. In the
euro area, more than 70% of financing for corporations is provided by banks, while this share
is about 20% in the United States. This means that the transmission of monetary policy in the
euro area relies to a considerable extent on banks, unlike the situation in the United States
where financial markets are more important in that respect. Therefore, the US Federal
Reserve engaged in large-scale outright purchases of, and guarantee schemes for, private
sector debt securities, in actual fact providing life support for several key financial markets,
while the ECB could resort to the more focussed enhanced credit support for banks.
In this respect, in order to better understand the ECB's monetary policy, especially in these
extraordinary circumstances, it is important to consider not only the actions that we took. It is
equally important to also look at measures that we did not take. In particular, we did not
engage in large-scale outright purchases of debt securities. Most of our liquidity provision
rests on refinancing operations, which have the character of repurchase agreements, and
are thus temporary loans. This will greatly facilitate the phasing-out of our exceptional
support. Nor did we engage in buying government securities. This would amount to the
monetisation of government debt, a sure road towards inflation over the medium term, with
adverse effects on our independence and credibility. All our actions were constantly guided
by our mandate under the Treaty, which is to safeguard price stability.
2.3 Understanding central bank interventions: a view on the balance sheet
Another, instructive way of looking at all these measures is to use the balance sheet of the
ECB. In an extremely stylised version, the balance sheet of the ECB resembles that of any
other central bank. On the asset side are its reserves (foreign currency holdings and gold)
and its own financial assets without reserve status. On the liability side, you will find its own
currency, the euro. Some of the euro amounts on the liability side take the form of reserve
requirements, so that banks are actually obliged to hold them. The larger proportion,
however, are accounted for by physical euro, i.e. banknotes and coins, which are held by
economic agents in the euro area and abroad, as well as by other central banks. It is
important to note that the willingness of economic agents to hold these liabilities ultimately
constitutes the capital of the central bank. This willingness is very closely related to the
reputation of the central bank and to the confidence economic agents have in the institution.
The demand of banks for the currency needs to be refinanced; technically, banks borrow
currency from the ECB and deposit collateral to secure the loan. These loans take the form
of refinancing operations and can be found on the asset side of the balance sheet of the
ECB.
Using this rather technical approach helps to distinguish the two phases of the financial
crisis.
During the initial phase of financial tensions, i.e. until September 2008, the balance sheet of
the ECB did not change much. In fact, overall liquidity provision was more or less
unchanged. There is one notable exception to this statement, namely the provision of
unlimited liquidity for two weeks over the turn of year 2007/2008, which resulted in a
temporary expansion of the ECB's balance sheet.
After September 2008, the balance sheet grew considerably in size. There are a number of
reasons for this. First of all, the volumes of refinancing operations increased as a result of the
procedure providing for fixed-rate tenders with full allotment, in which banks can themselves
determine the amount of liquidity they obtain. To the extent that these amounts were larger
than the underlying liquidity needs, banks simply left the liquidity in a special account with the
ECB, which is called the deposit facility. In effect, both sides of the balance sheet of the ECB
increased. Second, the covered bond purchase programme leads to an increase in the
assets of the ECB, which is paid for with currency. And, lastly, there was also more demand
for banknotes and coins, an increase of the liabilities - which leads to higher volumes in
refinancing operations on the asset side.
Technically speaking, you could say that the ECB used its balance sheet to grant banks
access to liquidity that was no longer available in the interbank market. Seen from a more
philosophical perspective, the ECB employed the trust euro area citizens have in the
institution and its currency to overcome a situation in which trust was scarce and badly
needed. With trust comes responsibility to use it only for worthy causes. The ECB is well
aware of this enormous responsibility, and its decisions are guided by it. The decision to buy
covered bonds, for example, was based on the insight that this asset class deserved our
support as its underlying incentive structure was, and is, sound and it economic basis robust.
Using the structure of central banks' balance sheets also allows the ECB's actions during the
crisis to be compared with those of the US Federal Reserve. In the United States, as
mentioned earlier, the financing for corporations is provided by banks to a far lesser extent
than in Europe. Most of the programmes enacted by the US Federal Reserve were,
therefore, aimed at directly stabilising key financial markets, which it did mainly via outright
purchases of debt securities and guarantee programmes for such securities. Since required
reserves of banks are much smaller in the United States, the resulting excess liquidity was
enormous, which caused the Federal Reserve to start paying interest on these excess
reserves in October 2008. In the case of the ECB, such a mechanism was already in place.
Required reserves of banks are remunerated at the average marginal rate of the refinancing
operations, and excess liquidity is remunerated with the rate of the deposit facility. Again, this
recent experience suggests that the ECB's operational framework provides a suitable and
robust toolkit for the implementation of monetary policy, even in difficult times. This view is
also increasingly being shared by other central banks.
Finally, I would like to address one particular question that I am often asked in connection
with the growth of our balance sheet: what are the consequences of this process for the
possible emergence of inflationary risks?
Again, knowledge of the ECB's balance sheet helps to answer this question. First of all, it is
important to note that the "excess liquidity", the amount of base money that exceeds the
reserve requirements and currency in circulation, does not stay in the market. Rather, it flows
back to the ECB via the deposit facility. So, from this perspective, our liquidity policy has no
inflationary impact. The abundant liquidity, however, has the effect of lowering money market
rates and, hence, impacts the price of capital. Here, our economic and monetary analyses
come into play in determining whether such rates are consistent with our mandate of
maintaining price stability and, at the moment, we have come to the conclusion that they are.
Although the liquidity provided by the ECB has increased substantially, this has not led to an
increase in monetary and credit aggregates. On the contrary, credit flows remain weak and
loan demand has not yet picked up.
This will, however, change at some point in the future, so that we are constantly monitoring
the situation. Again, you could gain an understanding of the dynamics of a pick-up in credit
demand and supply via the ECB's balance sheet. If banks increase their lending activities,
their reserve requirements would rise. All other things being equal, that would reduce the
amount of "excess liquidity", thereby transforming the balance sheet expansion of the ECB
into credit and economic growth, both of which entail inflationary risks. From this reasoning it
becomes clear that the timing will be crucial for the withdrawal of the enhanced credit
support, and that a strategy is needed to guide this process. Let me now turn to this topic.
2.4 Phasing out the enhanced credit support
There can be no doubt that the ECB's monetary policy currently provides substantial support
to the banking sector and the euro area economy as a whole. I would characterise our
current monetary policy stance as accommodating, which is appropriate in view of the fact
that neither the economic analysis nor the monetary analysis point to risks for price stability
at this stage.
It is clear, however, that our exceptional support cannot last for too long a period of time
since there are negative side effects.
•
The money market yield curve is currently strongly influenced by the abundant
liquidity in the market, i.e. short term money market rates are to some extent
distorted. If this situation persists for too long, it may contribute to a misallocation of
capital.
•
There is a clear risk of creating a dependency of banks on central bank refinancing,
while the intention of the current policy is only to "help banks to help themselves". It
may also slow down necessary structural adjustments to the balance sheets of
banks and, ultimately, to the business models of some financial institutions.
•
Risks to price stability will ultimately emerge from having this exceptional support in
place for too long a period of time.
For all these reasons, the ECB has an exit strategy in place to guide the process of phasing
out our enhanced credit support. This strategy can be activated at any time. Let me
elaborate.
Consistent with its mandate, the ECB needs to act if risks to price stability should emerge. In
other words, we have to avoid keeping policy rates at their current historically low levels for
too long. Changing policy rates does not necessarily entail a phasing-out of all the measures
of enhanced credit support. At the same time, our liquidity measures will not all be required
to the same extent as has been the case thus far. In particular, as mentioned earlier, we
should avoid setting wrong incentives by fostering banks' dependence on the ECB's
substantial liquidity support. This calls for our starting to phase out the enhanced credit
support as soon as money market conditions permit us to do so.
Let me use this reasoning to illustrate our exit strategy on the basis of two highly stylised
scenarios. Should money market conditions improve before upside risks to price stability
emerge, the enhanced credit support can be gradually withdrawn before we start changing
policy rates. This would not imply a change in the stance of our monetary policy as long as
the liquidity support would not be needed to the extent it has been so far. In this respect, we
will have a first opportunity to review the typology and modalities of our refinancing
operations at our first meeting in December. In case money market tensions persist while
upside risks to price stability emerge, some elements of the enhanced credit support would
need to remain in place. At the same time, policy rates could already be changed.
It is also important to stress that all measures of the enhanced credit support were designed
with the clear view to facilitating their phasing-out.
Let me reassure you that, not least thanks to our political independence and credibility, we
are well-equipped to act in a timely and prompt manner when the need arises. We continue
to monitor the stabilisation of the economic activity and financial markets very closely.
However, I would like to reiterate that not all our liquidity measures will be required to the
same extent as they have been necessary thus far.
3 After the storm: the future of monetary policy
What lessons can we learn from the causes of the crisis and the crisis itself for monetary
policy? Let me mention three key elements.
First of all, it seems that a central bank, especially in difficult times, is served well by having a
clear and unambiguous mandate, a robust strategy and a principles-based approach to
communication.
Second, the ECB does not need to change either its mandate or its strategy. Our mandate is
well-communicated and understood by the markets, while our strategy is suitable for fulfilling
this mandate and has proved to be robust. In particular, the ECB's strategy is
comprehensive. It includes the analysis of money, credit and asset prices. As such, it
provides a useful model for a monetary policy strategy that allows the medium-term risks to
price stability to be identified that result from imbalances in both domestic and global
markets.
This ties in with my third and final "lesson". A well-known topic is back on the agenda: the
role of asset prices for the conduct of monetary policy.
A long series of booms and busts in asset markets - occurring with increasing intensity and
frequency - over the last 40 years has shown that unsustainable trends in asset values can
pose serious threats to macroeconomic stability and, by implication, to price stability. The
current financial crisis - coming at the end of a long and tumultuous boom - has revived a
long-standing debate on the role that asset prices should play in the monetary policy strategy
of price stability-oriented central banks. In one camp of academics and experts are those
who claim that central banks should target asset prices and should, most notably,
incorporate some form of an asset price index into the price indicator that they use for their
respective definition of price stability. In the opposite camp are those who argue that it is too
difficult to extract "fundamental" dynamics from asset prices, to detect bubbles in real time
and, eventually, to devise an appropriate policy response with so blunt a tool as the policy
rate. According to this latter camp, monetary policy could, and should, deal only with the
eventual consequences of the bursting of a bubble.
Let me immediately say that the recent financial crisis has called into question the credibility
of the second position. One of the main lessons of the crisis is that central banks cannot
simply neglect asset price developments on the tacit understanding that - no matter how
large and unsustainable price trends might become - they will be able to intervene in the
aftermath of a crash to sweep up the pieces. The crisis has shown how costly this
understanding can be in terms of, first, distort