SPEECH
The transmission of monetary policy
Speech by Philip R. Lane, Member of the Executive Board of the
ECB, at the SUERF, CGEG|COLUMBIA|SIPA, EIB, SOCIÉTÉ
GÉNÉRALE conference on "EU and US Perspectives: New
Directions for Economic Policy"
New York, 11 October 2022
Introduction
In our September monetary policy meeting, the ECB's Governing Council communicated that, over the
next several meetings, we intend to raise our key policy rates towards levels that will ensure the timely
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return of inflation to our two per cent medium-term target.[
In identifying the appropriate levels for the key policy rates, a range of factors must be considered.
First, an assessment of the medium-term outlook for inflation is required: the quarterly staff
macroeconomic projection exercises provide important foundations, while each meeting also draws on
wide-ranging overviews of the latest economic, financial and market developments in order to develop
an assessment of both the most-likely medium-term inflation path and the balance of risks around that
path. Second, this assessment forms the basis for calculating the monetary policy path that is required
to eliminate in a timely manner the gap between the projected inflation rate (that would be expected to
materialise if monetary policy were not modified) and the two percent inflation target, while also
narrowing the distribution of inflation risks around the most-likely path.
This calibration stage crucially relies on a quantitative analysis of the various stages in the monetary
policy transmission mechanism. Working backwards, monetary policy can be viewed as affecting
inflation through two main channels: (a) reducing inflationary pressure by increasing economic slack
(lowering aggregate demand relative to the supply capacity of the economy); and (b) ensuring that
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medium-term inflation expectations are anchored at the two per cent target.[
The first channel can be de-composed into several links: (i) the link between our monetary policy
instruments - our policy rates, our balance sheet policies and our communication policy (including any
forward guidance) - and financial conditions; (ii) the link between financial conditions and economic
slack; and (iii) the link between economic slack and inflation pressures. The second channel can be
broken down into a further two elements: (iv) if inflation expectations are broadly anchored, the
monetary policy needed to ensure expectations remain anchored; and (v) if inflation expectations are
de-anchored (or at serious risk of being de-anchored), the monetary policy needed to ensure inflation
expectations are re-anchored.
In what follows, I will discuss some of the challenges in forming quantitative assessments of the
strength of these various mechanisms. First, I will discuss the various mechanisms by which monetary
policy operates. Second, I will assess how the considerable shift in monetary policy during this year is
being transmitted.
However, from the outset, it is essential to make three basic points. First, monetary policy is always
decided under conditions of uncertainty: not only uncertainty about inflation dynamics but also
uncertainty about each of the channels connecting medium-term inflation to our monetary policy
instruments. This uncertainty is mitigated to some extent by taking a meeting-by-meeting approach to
calibrating monetary policy, such that the latest information can be incorporated (including updates on
the strength of the transmission mechanism). Second, the considerable lags between monetary policy
actions and their impact on inflation outcomes also imply that much of the near-term attention in
assessing monetary policy actions focuses on the transmission to financial conditions (and, where
feasible, inflation expectations). Assessing the ultimate impact on inflation dynamics, meanwhile, must
rely on analytical tools that seek to draw on the historical evidence in the most informative way,
recognising the relevant differences across previous inflation episodes. Third, in the absence of further
shocks, the profile of euro area inflation over the next 12 to 18 months will be primarily driven by the
fading impact of past supply shocks and the deceleration in demand that is signalled by the latest
confidence indicators: the role of monetary policy is to ensure that the "residual" inflation dynamic
returns to target in a timely manner.
The transmission channels of monetary policy
Let me start by outlining the main transmission channels of monetary policy. Conceptually, the
monetary policy transmission process can be divided into upstream stages of transmission and
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downstream effects.[ The upstream stages include our steering of the short-term money market
conditions and how these propagate to the risk-free and sovereign yield curves (mainly through
expectations of the future path of policy rates). The downstream effects are captured by the
adjustments in the cost and volume of external finance available to the firms and households that are
dependent on banks for access to credit. I will begin with the upstream stages of the transmission
mechanism and then turn to the downstream effects.
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Monetary policy works through its influence on the entire yield curve.[ Changes in the policy rates
directly affect only very short-term money-market interest rates. But the expectations of future policy
rates are a primary determinant of medium and long-term interest rates, together with term premia. It
is the adjustment in term interest rates along the risk-free and sovereign curve that matters most for
the economy, as these directly affect the conditions under which firms, banks and governments can
borrow in financial markets and indirectly affect the cost of borrowing of firms and households to the
extent that they rely on bank borrowing, since banks price their loans off the risk-free or sovereign
yield curve.
In addition to the rate expectations mechanism, our securities holdings are still bearing down on
longterm interest rates through what is known as the duration extraction effect. Duration risk exposure is
costly for private investors, as they need to set aside capital and balance sheet space to bear this type
of exposure. This is why investors demand compensation in the form of higher expected returns when
locking in long-dated fixed-income investments, which in turn translates into higher term premia and
long-term yields. In purchasing long-dated assets, a central bank takes duration risk off private hands,
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which translates into lower term premia and long-term interest rates.[ As the Eurosystem - in
common with many other central banks - still holds a considerable portion of the universe of
eurodenominated bonds, our holdings are still exerting downward pressure (albeit more weakly) on term
premia and long-term yields.
The extent to which a reduction of the central bank balance sheet operates in a fashion that is fully
symmetric to the effects of expanding the balance sheet still awaits to be authoritatively settled, given
the dearth of sufficient evidence on episodes of bond portfolio wind-downs. This being said, the
available analysis finds that some of the channels that are found to have been important in explaining
the transmission of quantitative easing - announcement and signalling effects - may be absent or
much diminished if the size of the balance sheet is reduced along a much more gradual and
predictable path than the discrete and often unexpected actions through which QE was conducted in
the past. At the same time, some other channels, such as the duration channel or liquidity effects, will
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probably either operate symmetrically or will be magnified.[ Moreover, the degree of financial market
distress during the expansionary and contractionary phase and, in particular in the euro area context,
the complementarities between asset purchases, rate guidance and the negative interest rate policy
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are likely to be relevant factors.[
Overall, a tentative conclusion about the impact of balance sheet actions on financial conditions in a
normalisation phase is that the signalling channel will be weaker for a given adjustment to the size and
composition of our balance sheet than it was in a phase when our asset purchase programmes
resulted in a rapid increase in our securities holdings during a relatively short period.
However, the signalling effects emanating from a given rate adjustment may well be larger than it is
estimated to have been the case prior to the financial crisis. First, the exit from the negative interest
rate policy may have strengthened the transmission of a rate hike throughout the term structure of
interest rates. This would be the case if the unwinding of the outsized downward pressure on
longterm yields that is estimated to have been associated with rate cuts in the negative territory was
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symmetric.[ Second, the retirement of rate forward guidance after years in which forward indications
about the likely future path of interest rates had suppressed rate volatility almost entirely may invite
markets to react to a rate increase by pulling back more sharply from longer-term securities as dealers
and other providers of trading liquidity are less willing to put capital at risk to make two-sided markets
in a context of perceived higher interest rate uncertainty. This may exert greater upward pressure on
term premia and the level of long-term yields.
The risk of snap-back in term premia and the sudden repricing of rate expectations warrant close
monitoring from a market functioning and broader financial stability perspective.
Interest rate and cash-flow channels
Interest rate changes affect households and firms through several channels. First, via the
intertemporal substitution channel, higher interest rates provide incentives to households to save more
now and postpone consumption from the present to the future. Second, all else being equal, higher
interest rates lower asset prices (bond values, equity values and property values), with the resulting
decrease in wealth discouraging spending through the wealth channel and reducing the scope to
pledge collateral in debt transactions.
The role of equity markets is particularly important for firms with higher growth opportunities, whose
risk profile is typically more suited to market financing instruments with the possibility of risk-sharing
(including private equity or "alternative investment" funds) rather than conventional bank debt. Recent
studies suggest that there is a financing gap in Europe for potential growth companies relative to other
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economies, which significant drops in equity valuations would tend to aggravate.[
In parallel, the relevance of asset prices may have increased for households, following the significant
growth in house prices. Moreover, after a large fall of their investment in financial markets following the
Lehman crisis, the share of equity holdings in the aggregate financial wealth of households has been
increasing.
Third, the cash-flow channel operates through the impact of higher interest rates on the income and
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expenses of households and firms.[ Across households and firms, the size and sign of cash flow
effects depend on whether these are in net borrowing or net saving positions, the relative exposure to
variable rate versus fixed rate debt (Chart 1), and the degree to which financial constraints are
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binding.[ In one direction, higher interest rates raise interest payments by indebted households
and corporates, which reduces the cash flow available for spending. A similar effect applies to the
interest expenses of the fiscal authority, which may crowd out primary spending to the extent that
governments react to an increase in borrowing costs by compressing discretionary outlays.
In the other direction, higher interest rates increase the interest revenues on the interest-bearing
assets held by households and firms. Changes in interest rates also directly affect the liquidity and
balance sheet strength of firms, which may adjust their investment spending in response, especially if
these are financially constrained.
Whereas variable-rate debt reflects changing interest rates almost immediately, fixed-rate debt does
so only over time. While at the euro area level around 70 per cent of outstanding loans to households
are at a fixed interest rate, this share is as high as around 90 per cent in France and Germany and as
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low as 25 per cent in Spain and Italy.[ This in turn points to relevant differences in the speed at
which interest rate changes are passed through to households and firms.
Chart 1: Share of fixed-rate loans for households and firms in the euro area
(percentages, based on amounts outstanding)
Source: ECB (BSI).
Latest observation: August 2022.
Bank lending channel
In the euro area's bank-centred economy, the bank lending channel plays an important role. It covers
the transmission through banks to a larger share of firms, also including smaller firms which do not
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issue bonds, as well as to households.[
Bank funding costs are the first important element in the bank lending transmission channel. For about
half of banking-sector liabilities, corresponding to debt securities and wholesale deposits, the
remuneration is closely linked to market rates and therefore passed through quickly to the marginal
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funding costs of banks.[ By contrast, retail deposit rates adjust more sluggishly, keeping the rise in
bank funding costs contained in a period of interest rate increases.
In addition, TLTROs allowed for a compression in the intermediation wedge - the difference between
the cost of loans and the risk-free interest rate. TLTRO therefore operated primarily via the bank
lending channel - by providing funding certainty at attractive rates, which lowered the cost of loans for
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households and firms - rather than via risk free rates.[ At the same time, in the absence of new
operations, TLTROs no longer have a direct accommodative contribution to the marginal funding costs
of banks.
The increase in market rates is transmitted via bank funding costs to bank lending rates on new loans
(the interest rate channel) as well as via repricing of the existing stock of flexible-rate debt. In relation
to the former, banks apply a markup on top of their funding cost, depending on borrower risk
characteristics. In addition, increasing interest rates, typically associated with a decline in asset prices,
may lower the value of collateral and hence determine an increase in lending rates over and beyond
that associated with higher base rates and thereby impede access to bank loans. Furthermore, tight
monetary policy drains reserves from the banking system, limiting the ability of banks to supply credit.
As a result of the several steps in the transmission of monetary policy via the banking system, the
pass-through of monetary policy to lending rates on new loans is slower than to market-based debt
(Chart 2). Using historical regularities (excluding the COVID period due to its exceptional character), a
commonly used measure looks at the percentage of changes in market rates which translates over
time into changes in lending rates on new loans (i.e. the so-called pass-through). Looking at
passthrough measures, the repricing of corporate debt securities is much faster than the repricing of bank
loans. In particular, a change in market rates is fully transmitted to a corresponding change in
corporate bond yields within the same quarter (the pass-through rate is about one), while for lending
rates it usually takes about six months to one year until changes in market rates are passed through to
corporate bank lending rates.
Chart 2: Pass-through of changes in market rates to lending and debt securities rates
over time
(x-axis: time horizon; y-axis: percentages)
Sources: ECB (MIR, BSI), IHS Markit iBoxx and ECB calculations.
Notes: Estimates of lending rates pass-through are from Altavilla, C, F. Canova and Ciccarelli M., Mending the
broken link: Heterogeneous bank lending rates and monetary policy pass-through, Journal of Monetary
Economics 2020, Volume 110, 2020, Pages 81-98.
In addition to the transmission via lending rates, monetary policy is also transmitted to borrowers by
banks adjusting their credit standards. Data on bank lending standards are collected directly from the
banks in the euro area bank lending survey and monitored carefully to obtain early signals on future
loan growth developments.
Risk-taking channel
An extended period of historically low interest rates in the aftermath of the financial crisis has fostered
research on whether economic agents, in those conditions, might be encouraged to take on more risk
and search for investment assets and strategies that generate higher investment returns. Importantly,
banks and other investors may also be subject to excessive tolerance of risk in a low-return
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environment.[ These may not adequately adjust their expectations about future interest rates,
assuming instead that rates will remain low for an extended period. This, in turn, may encourage
banks to expand their balance sheets through leverage and originate an excessive amount of
lowerquality credit because of softened lending standards.
The build-up of financial imbalances associated with the over-expansion of the balance sheets of
banks and other financial intermediaries makes them vulnerable to a pivot in monetary policy, leading
in the most extreme case to a rapid unwinding of those positions as investors become risk averse.
This can lead to an amplified effect of a firming in the monetary policy stance through generalised
conditions of reduced liquidity and forced asset sales.
Exchange rate channel
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Finally, interest rate and balance sheet policies also operate through an exchange rate channel.[
The uncovered interest rate parity (UIP) suggests that an upward shift in the risk-adjusted forward rate
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curve brings about an appreciation of the euro.[ Simple correlations between the exchange rate and
interest rate expectations suggest that this relation has held up reasonably well historically and more
recently in terms of the euro-US dollar bilateral exchange rate as well as in the cross-section of the
effective exchange rates of major currencies.
ECB model-based decompositions of financial asset price movements across the United States and
the euro area point to a prominent role of US monetary policy tightening in driving the increase in euro
area yields, the correction in euro area equity markets, and the recent euro depreciation. In fact, US
monetary policy spillovers have had at least as much of an impact on euro area asset prices and the
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euro-dollar exchange rate over the last 12 months as ECB monetary policy actions.[ At the same
time, while both rate normalisation and balance sheet normalisation in the euro area, all other things
being equal, can be expected to exert appreciation pressure on the euro exchange rate, rate policies
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exert a stronger exchange rate effect than balance sheet policies.[
Spillovers
The deeply integrated nature of the global economy implies that our analysis needs to incorporate
international monetary policy spillovers. For instance, changes in the interest rate locally affects
domestic consumption and investment, which in turn affects the demand for imports from trading
partners, and hence output abroad ("demand channel"). Via the financial channel, changes in the
interest rates of major central banks can propagate across borders via asset price spillovers to bond
yields, corporate earnings expectations and financial risk premia.
Since the bulk of cross-border capital flows are denominated in US dollar, as the US dollar plays a
dominant role, and as US monetary policy is a key driver of the global financial cycle, US interest rate
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changes have more pronounced repercussions on the rest of the world, including the euro area.
This is also reflected in ECB staff analysis, which indicates that a Fed tightening elicits large
contractionary effects on real activity and eventually inflation in the euro area. These contractionary
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effects are, in fact, as large as the domestic effects in the United States.[ Overall, given the open
nature of the euro area economy, cross-border channels are crucial in evaluating how our policy
stance transmits to the euro area, while also influencing global economic and financial conditions.
Risk-sharing
A distinct feature of monetary policy in a monetary union is that it might entail differences in
transmission across countries or regions, reflecting differences in the financial structure or other
country-specific factors. For example, as noted above, the speed at which interest rate changes are
passed through to households and firms might differ across euro area countries due to differences in
the share of variable-rate loans. In addition, recent analysis by ECB staff suggests that the extent of
international risk sharing plays a key role in shaping the real effects of monetary policy shocks in euro
area regions. In particular, a monetary policy tightening is associated with a stronger output
contraction, the lower is the degree of risk sharing in a region. Moreover, regions with a higher degree
of risk sharing are less prone to persistent economic effects of interest rate changes (Chart 3): while
output in regions with minimum risk sharing remains around 1.5 percentage points below its initial level
five years after a monetary policy tightening shock, it fully recovers over this period in regions with
maximum risk sharing.
Chart 3: Impact of monetary policy on regional output when risk sharing is high or low
(x-axis: years; y-axis: percentages)
Source: Hauptmeier, Holm-Hadulla and Renault (forthcoming), "Risk sharing and monetary policy transmission",
Working Paper Series, ECB.
Notes: The chart shows the impact of a 100 basis point policy rate hike on regional output for low (blue) and high
(red) levels of total risk sharing for a sample consisting of 155 regions from ten euro area countries over the
period 2000-18 at an annual frequency. The x-axis refers to the horizon in years of the output response. The
effect of the monetary policy shock is estimated with local linear projections.
The anchoring of inflation expectations
It is an essential task for monetary policy to ensure that medium-term inflation expectations are
anchored at the two per cent target. The scale and speed of the rise in inflation since the middle of
2021 constitutes a major shock and has created an environment in which there is more intense
questioning of the future inflation path. The longer and larger the deviation from the two percent target,
the greater the risk that medium-term inflation expectations become de-anchored.
All else equal, the monetary policy that stabilises inflation at target in a timely manner is also the
monetary policy that stabilises expectations at target. First, by ensuring that the monetary policy
stance will sufficiently dampen demand to return inflation to the target in a timely manner, price setters
and wage setters are on notice that demand conditions will not sustain excessive price increases and
wage increases. Second, clear communication of the effectiveness of our monetary policy measures
and of our determination to adjust monetary policy in response to the evolving inflation outlook also
helps households, firms, experts and markets to cut through the noise in the current highly uncertain
environment and thereby helps to maintain the anchor for inflation expectations.
Model-based impact of an interest rate shock
So far, I have listed a range of channels by which monetary policy transmits to the financial system,
the economy and, ultimately, inflation dynamics. In order to provide an integrated macroeconomic
assessment, I will now turn to a discussion of model-based quantification of the overall impact of
interest rate policy.
Monetary policy transmission to the real economy typically entails considerable lags. It takes a
sequence of reactions for the change in financing conditions to fully feed through to demand, and from
demand to inflation. ECB model-based staff analysis suggests that, on average, the impact on inflation
of a 100 basis point policy rate shock builds up gradually over time to reach its peak impact during the
second year following the initial shock (Chart 4). Across models, the time interval tends to be the
shorter, the more forward-looking are agents, as the adjustment in demand becomes more
frontloaded.
This corresponds to the hypothetical case of an isolated and temporary change in the policy rate, and
the macroeconomic impact associated with the on-going normalisation - which includes a sequence of
persistent changes in interest rates that extend into expectations for the future - is likely to be larger
and more persistent than suggested by these standard model responses. At the same time, drawing
on these estimates certainly implies that monetary policy cannot bring inflation back to target in the
short run. In this respect, our medium-term orientation acknowledges this lag and allows to also
account for uncertainties in the inflation process and the transmission mechanism.
The impact of monetary policy on real output at the aggregate level conceals some differences across
sectors and industries. In particular, consumer demand for housing and durable goods is traditionally
more sensitive to interest rate changes and therefore tends to be more responsive to monetary policy.
More broadly, differences in monetary policy transmission across sectors can be related to differences
in financial structure, in particular the maturity structure of debt, the coverage ratio, financial leverage
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and firm size.[
Coming to the assessment of the macroeconomic impact of normalisation, ECB staff estimates, based
on a suite of macroeconomic models regularly used for policy analysis at the ECB, indicate that the
change in the short-to-medium term structure of interest rates and balance sheet expectations since
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December 2021 is expected to compress inflation by more than one percentage point in 2024.[
At the same time, the ECB's Governing Council is fully aware that further ground needs to be covered
in the next several meetings to exit from the prevailing highly accommodative level of policy rates. It
should also be clear that any quantitative estimates are surrounded by significant uncertainty. One
dimension of this uncertainty is captured by the range of estimates across models. In particular, the
impact tends to be larger in those models that embed a more elaborated financial block that supports
real-financial amplification effects and models that feature stronger expectation and confidence
channels as entailed in DSGE-type models. In addition, models that can better account for the
conditional correlations between identified monetary policy impulses and macroeconomic aggregates,
as opposed to more reduced-form models, tend to exhibit a stronger impact of monetary policy.
Such uncertainty motivates the ECB's staff choice to use a suite of models that spans different
modelling classes, ranging from fully structural dynamic general equilibrium models to semi-structural
models. This notwithstanding, in the current situation of exceptionally high inflation, uncertainty has
significantly increased beyond the historically regularities captured by the available models. Finally,
these estimates do not capture the benefit of preventing adverse non-linear dynamics that could
materialise in the absence of policy decisions, which could risk destabilising inflation expectations
down the road. Accounting for these non-linear dynamics is challenging but would likely point to a
larger impact of monetary policy than captured here.
Chart 4: Response to a standard monetary policy shock: comparison across models
(deviation from baseline in percentage points)
Sources: ECB staff calculations.
Notes: This chart depicts the impulse responses of real output and inflation to a standard short-term interest rate
shock (normalised to 100 basis points) for the ECB-BASE model, the ECB New Area Wide Model (NAWM) and
the MMR model. Real output refers to the output gap as a percentage of GDP. Inflation is in year-on-year
percentage change. All responses refer to deviation from the baseline in percentage points.
Policy effects in international comparison - the role of financial
structure
Structural features imply differences in transmission of monetary policy both across countries and over
time. Some euro area financial structures may currently dampen the impact of monetary policy in the
euro area compared to the past (typically those features relate to interest rate fixation in private
borrowing), while others (first and foremost the disruptions in energy supply) may act as amplifiers.
While high inflation certainly reflects global factors related to the rise in energy costs and supply
bottlenecks, each central bank faces structures which are unique to their jurisdictions and influence
the transmission of monetary policy.
Chart 5: Ratio between bonds and loans for firms in the euro area versus United
States
(ratio of outstanding amounts)
Sources: ECB and Federal Reserve Board.
Note: The latest observation is for the second quarter of 2022.
As a more bank-based system, the euro area might entail a more delayed reaction through the interest
rate channel, as compared to countries where firms finance themselves predominantly with
marketbased debt (Chart 5). This is due to the slower speed of pass-through of market rate changes into
lending rates on new loans compared with corporate bond yields. As already hinted previously, firms in
the euro area rely predominantly on banks for their external financing compared to the United States.
This implies that the same policy actions might take more time in the euro area to be transmitted to the
average firm in the economy Over the last decade, larger euro area firms have increased recourse to
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market-based finance.[ This may slightly accelerate the pass-through of monetary policy, even if
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pass-through in the US remains faster by comparison.[ Central banks take such lags into account
when setting their policy action and monitor carefully the pass-through via financial markets and the
banking system.
Another factor behind current differences in transmission is that European firms are more affected than
firms in other jurisdictions by disruptions in energy supply (Chart 6). In particular, higher exposures to
energy imports from Russia imply higher upward pressure on prices via higher commodity prices. It
may also entail higher borrower risk and thus banks applying higher lending rates to firms, compared
to a no-war counterfactual. These higher lending rates would negatively affect investments and
aggregate demand, thus exerting downward pressure on domestic inflation.
Chart 6: Main energy importers from Russia
(percentage of total imports in 2019)
Sources: Trade Data Monitor and ECB calculations.
Notes: Products considered are crude petroleum (2709), refined petroleum (2710), petroleum gas (2711) and coal
(2701). Latest observation is for 2019.
Turning to households, on the one hand, their indebtedness is generally lower in the euro area than in
the United States. This implies a weaker response of consumption to monetary policy in the euro area
(Chart 7). This was even more the case before the Great Financial Crisis, after which US households
deleveraged to a great extent. Euro area household debt stands at overall moderate levels, somewhat
above the level at the start of the pandemic in 2019, but considerably lower than for US households.
The low interest rate environment in recent years has meant a considerable reduction in the interest
payments made by households. Looking ahead, due to higher interest rates, gross interest payments
in the euro area can be expected to rise by only a limited extent, in view of relatively contained
household debt levels and the extent of fixed-rate contracts. However, compared to the US, this
increase in interest payments may happen more quickly, in view of the importance of variable-rate
mortgages in some parts of the euro area.
Furthermore, estimates of so called 'wealthy-hand-to-mouth' (i.e. households with significant illiquid
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wealth, limited liquid wealth and elevated debt) are consistently lower than in the US.[ Recent
research indicates that a lower share of such households also translates into a lower marginal
propensity to consume by households and thus a weaker transmission mechanism.
Chart 7: Household debt: United States vers