José Manuel González-Páramo: The conduct of monetary policy -
lessons from the crisis and challenges for the coming years
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the SEACEN-CEMLA Conference, Kuala Lumpur, 13 October
2011.
* * *
I would like to thank Conception Alonso, Alain Durré and Cornelia Holthausen for their inputs to this speech.
1. Introduction
Ladies and Gentlemen:
It is a pleasure for me to attend the SEACEN-CEMLA Conference, as it offers me a new
opportunity to describe and explain to my esteemed colleagues from other parts of the world
the experience of the ECB's monetary policy over the past four years of crisis. I would also
like to take the opportunity to discuss with you what I consider to be some of the main
challenges that modern central banking will have to face in the future.
With the benefit of hindsight, I should say that the implementation of monetary policy was
relatively straightforward during normal times. The Governing Council of the Eurosystem
decided on the level of the key ECB interest rates, following a comprehensive assessment of
the outlook for price stability and the associated risks, based on its economic and monetary
analyses. The Executive Board of the ECB then organised the refinancing operations with
eligible counterparts in order to implement the decision of the Governing Council. And it did
so in a relatively "standard" fashion, employing a relatively small set of instruments in a
rather predictable way.
Through its refinancing operations, the ECB aims at supplying the amount of liquidity that is
necessary for a smoothly operating banking system, influencing short-term money market
interest rates to align them with the policy stance signalled by the Governing Council.
Through the money market yield curve, the monetary policy stance is transmitted to the
pricing of financial instruments, and credit conditions more generally. These conditions in
turn influence saving and investment decisions and monetary dynamics in the economy
which finally also influence price developments in the euro area.
The operational framework is the initial link between the key ECB policy rates and money
market rates. It supports the fulfilment of the ECB's mandate for price stability by letting
monetary policy decisions feed through as quickly and precisely as possible to short-term
money market rates.
Let me now explain in greater detail the many challenges that the ECB had to face when
implementing its monetary policy during the financial crisis.
2. The ECB's monetary policy framework during "normal" and "turbulent" times
The assessment of the monetary policy stance is essential in order to be able to make the
right interest rate decisions at the appropriate time. In the case of the ECB, this assessment
has two elements: i) the formation of a view on the medium-term inflation outlook and, in
particular, the risks to price stability, based on the interaction of supply and demand in
various markets (economic analysis); and ii) the identification of the monetary impulses from
current and past monetary policy decisions taking into account that these impulses are
always transmitted to the economy with a certain lag (monetary analysis).
Needless to say that assessing the monetary policy stance in real time is always a
challenging exercise. This is even more so in turbulent periods when there is a high degree
of uncertainty surrounding current and future economic conditions and the functioning of the
economy, including the transmission of monetary policy itself. The assessment of the
appropriate monetary policy stance must therefore be broad-based and forward-looking,
encompassing all the information relevant to the formation of a view on the risks to price
stability over the medium term, including the potential impact on price developments of risks
to the growth outlook.
Monetary policy decisions may only affect the developments of economic variables in the
intended way if financial markets efficiently transmit the initial monetary impulses along the
yield curve. This requires that money markets, as well as broader financial markets, are
functioning properly. If this condition is not met, it may become necessary for central banks
to take action to ensure that the monetary policy transmission channel continues to work
effectively, while at the same time continuing to assess the appropriateness of the monetary
policy stance given changes in the economic environment. If the central bank did not act to
prevent markets from becoming dysfunctional, its decisions over monetary policy rates would
remain purely theoretical. Its decisions would have little or no impact on the real economy
and the impact itself would become increasingly difficult to predict. This is precisely what led
the ECB to implement various "unconventional measures" during the different stages of the
financial crisis. I will elaborate more on this, as well as on the new measures that the ECB
announced on 6 October, in a moment.
By construction, the monetary policy framework of the ECB (i.e. the decision on the
appropriate level of interest rates and the management of inter-bank liquidity conditions
needed to implement this decision) implies a separation between monetary policy decisions,
on the one hand, and the implementation of the desired monetary policy stance through open
market operations, on the other. A clear distinction therefore has to be maintained between
interest rate decisions taken to preserve price stability (i.e. the determination of the monetary
policy stance) and liquidity decisions taken in the course of implementing this stance.
This distinction is useful both under normal market conditions and in periods of financial
turbulence, albeit for somewhat different reasons. In normal times, this so-called "separation
principle" allows the central bank to fine-tune operational procedures in order to steer
shortterm interest rates very close to the main policy rate, without risking that those adjustments
are regarded by observers as changes to the monetary policy stance. In exceptional
circumstances, when severe distortions in financial markets emerge (reflected, for instance,
in volatile and rising money market spreads), a more non-standard liquidity management by
the central bank may be needed without jeopardising the central bank's main monetary
policy objective. Against this background, the so-called "unconventional measures"
implemented by the ECB during the crisis still aim mainly at implementing the monetary
policy stance by contributing to restoring the smooth distribution of liquidity in the money
market. It is along those lines that the ECB's actions during the ongoing financial crisis must
be understood.
It is the view of the ECB that the role of a central bank under any circumstances, and in crisis
times in particular, is to inflexibly pursue its main objective, which in the ECB's case is
pricestability, and to perform as a key anchor of stability. This implies very careful analyses of any
sudden unexpected shocks before considering a change to its monetary policy stance. In the
same vein, the ECB also must assess in real time the effectiveness of its actions in order to
be able to decide at the right time whether or not to phase out the exceptional measures
implemented to cope with exceptional events. This is the main reason why the ECB never
pre-commits to any particular future policy stance or measure. Given the high level of
uncertainty that exists in a crisis environment, any pre-commitment would risk persisting with
a particular policy stance even when this stance is judged to no longer be appropriate by the
ECB on the basis of its assessment of the most up to date information.
As regards the additional liquidity providing operations introduced by the ECB during the
crisis, let me mention that these non-standard measures have been enacted at positive
interest rates throughout the financial turmoil, even though the level of policy rates was close
to a lower bound. In normal times, remunerating reserves allowed banks to have convenient
buffers to face liquidity shocks at low costs. In crisis times, it proved to be insufficient.
Nevertheless, the link between the policy rate and the remuneration rate on required
reserves allowed us to conduct non-standard measures with positive (non zero) policy rates,
and hence without affecting the costs of keeping high level of reserves at the ECB. In
addition, the rate that the ECB pays on cash placed overnight on our deposit facility in effect
sets a floor for short term money market rates. Throughout the crisis, the EONIA, the index
for euro-area overnight money market interest rates, always fluctuated at levels above the
deposit facility rate. Especially in periods with a very high degree of liquidity provision,
EONIA tended to be quite close to the deposit facility rate, but the difference remained
always positive. Consequently, it was possible in the euro area to conduct non-standard
measures at low, but positive short-term interest rates consistent with a reasonably
functioning inter-bank money market.
Let me now turn to the details of the measures taken by the Eurosystem during the past four
years of financial market turmoil.
3. The ECB's monetary policy during the financial crisis
The implementation of the ECB's monetary policy during the crisis can be divided into four
phases in the period between 9 August 2007 and October 2011.1
The first phase - which we can call the "Market Turmoil" phase - runs from 9 August 2007 -
the day the French bank BNP Paribas announced that it suspended the redemption of
shares in its funds that had invested in sub-prime mortgages - until 15 September 2008 -
the day Lehman Brothers failed. The main challenges faced by the ECB during this period
were to calibrate adequately the "right" amount and timing of frontloading of liquidity, to be
able to continue steering the overnight interest rate without relying on "too" frequent
interventions. This was done in an environment where the reserve averaging mechanism -
which under normal market conditions ensures a stable interest rate path - was no longer
sufficient to stabilize money market conditions. There were various reasons for this, including
the hoarding of liquidity by banks, heightened aversion by banks to counterparty credit risk
and increased cross border market segmentation. In addition to these factors, liquidity in the
inter-bank market was also negatively affected both by the idiosyncratic liquidity uncertainty
faced by individual banks and the aggregate liquidity uncertainty faced by the banking
system as a whole. During this phase, the ECB also needed to determine the appropriate
split in the provision of liquidity between short- and longer-term refinancing operations
subject to market participants' preferences.
The second phase - which we can call the "Financial Crisis" phase - covers the last quarter
of 2008 and the first three quarters of 2009. This period was marked by a sharp contraction
in world output and trade followed by a sluggish recovery. In fact, in the autumn and winter of
2008/09, macroeconomic developments tracked very closely those observed at the start of
the Great Depression of the 1930s. During this period the Eurosystem implemented
"nonstandard" monetary policy measures. Against the background of a sharp contraction in World
output and trade and in reaction to increasingly dysfunctional money and financial markets,
the ECB took bold steps to support the banking system which is at the core of the monetary
policy transmission mechanism in the euro area. In terms of conventional monetary policy
the ECB cut the minimum bid rate (MBR) in a sequence of steps from 4.25% to a record low
of 1%. In terms of non-conventional measures the ECB announced that it would conduct all
of its refinancing operations at a fixed rate (the MBR rate) with full allotment. At the same
time the ECB decided to narrow the interest rate corridor of its standing facilities. The
eligibility criteria for collateral was temporarily extended and the credit threshold for eligibility
was lowered from A- to BBB- for marketable assets (except ABS) and non-marketable assets
(with an additional haircut). In July 2009 the ECB also launched its first Covered Bond
Purchase Programme (CBPP) with the intention of supporting a financial market segment
that is particularly important for the longer-term funding of banks and the financing of the real
economy in the euro area and which had become dysfunctional during the crisis. The ECB
also strengthened its international coordination with other central banks through initiatives
like re-activating US dollar liquidity providing operations. These type of operations had
already been implemented in December 2007, following the establishment of bi-lateral
currency swap agreements with the Fed, but in 2008 they were offered under the fixed-rate
full-allotment tender modality and with longer maturities.
These measures were implemented with a view to re-establishing market functioning so that
the transmission of monetary policy would continue to work. The fear was that the
malfunctioning of financial markets would lead to a deterioration of credit conditions and spill
over to the real economy. Indeed, as recent ECB research shows, banks with weaker core
capital positions, and greater dependence on market funding and on non-interest sources of
income, restricted their loan supply more strongly than other banks during the crisis (see
Marquez and Gambacorta, 2011).
The third phase, which we can call the "Phasing-Out" phase, spanned the period between
December 2009 to April 2010. During this phase the Eurosystem announced and initiated the
gradual phasing-out from the "non-standard" policy measures. The ECB began this process
by not renewing the one-year longer-term refinancing operations and other supplementary
refinancing operations with maturities of 3- and 6-months, which reduced the liquidity surplus
in the interbank market as the old operation began to expire. On the collateral side, eligibility
requirements for ABSs were tightened (in December 2009) and the expiry date for the other
temporary collateral measures, like the enlargement of the list of collateral assets and the
reduction of the rating threshold, was initially set for the end of 2010. In addition, the supply
of USD liquidity providing operations was discontinued and variable rate tender procedures
were reintroduced for regular 3-month refinancing operations.
The intensification of the sovereign debt crisis, which had started in late 2009 and peaked for
the first time in the spring of 2010, however, led to a re-assessment by the ECB of the
appropriateness of embarking on the phasing-out process. This re-assessment marks the
beginning of what one could call "the fourth phase", or the "sovereign debt crisis phase", in
which we are still in. In early 2010, the sovereign bond spreads of several euro area
countries, relative to German bonds, widened sharply. Even though these developments
could be interpreted as the result of growing market concerns about the sustainability of
public finances in Greece, clear signs of contagion to other euro area bond markets emerged
towards the spring of 2010. This contagion affected Ireland and Portugal and, eventually,
also Spain and Italy. Sovereign bond markets in an increasing number of euro area countries
began to become dysfunctional. This weakened the transmission channel of monetary policy
decisions to financial markets and broader financing conditions in the economy. In order to
address this problem, on 10 May 2010, the ECB launched the Securities Market Programme
(SMP) under which it conducts outright purchases of euro area debt securities in the
secondary market. Although the SMP remained inactive for a period of around four months
between April and August 2011, following renewed tensions in euro area sovereign bond
markets, the ECB announced on 7 August 2011 that it would resume purchases under this
programme. This took place after the announcement of new fiscal and structural policy
measures by the Italian and Spanish governments.
A key distinguishing feature of asset purchases made under the SMP is that their liquidity
impact has been sterilised through the conduct of weekly liquidity absorbing operations.
Overall, there has been no net injection of central bank liquidity to the market as a
consequence of these operations. These measures and their objectives are therefore
fundamentally different from quantitative easing.
On 6 October the ECB announced a number of important additional non-standard measures.
First, the Governing Council decided to conduct two new longer-term refinancing operations
(LTROs), with maturities of 12 and 13 months, with the fixed-rate full-allotment tender
procedures. The rate in both operations will be fixed at the average rate of the main
refinancing operations over the life of these respective LTROs.
Second, main refinancing operations (MROs) will continue to be conducted with fixed-rate
full-allotment tender procedures for as long as necessary, and at least until 10 July 2012.
This procedure will also remain in use for the special-term refinancing operations with a
maturity of one maintenance period, which will continue to be conducted for as long as
needed, and at least until the end of the second quarter of 2012. The fixed rate in these
special-term refinancing operations will be the same as the MRO rate prevailing at the time.
The six LTROs with maturities of three-months that will be conducted in the first half of 2012
will also be conducted with fixed-rate full-allotment tender procedures. The rates in these
three-month operations will be fixed at the average rate of the MROs over the life of the
respective LTRO.
Third, a new covered bond purchase programme (CBPP2) will be launched. Under the
CBPP2 the Eurosystem will purchase, in both primary and secondary markets, covered
bonds for a total value of EUR 40 billion over a period on one year beginning in November
2011. Further details on the modalities of CBPP2 will be announced after the Governing
Council meeting of 3 November 2011.
4. Challenges ahead
After four years of financial market turmoil, market conditions in many countries, including the
euro area, remain exceptionally fragile. In response, the Eurosystem continues to provide
support to euro area money markets in the ways I have just described. Such support should
prove beneficial if three principles are followed: it should be timely, targeted and temporary.
The ECB's interventions have been timely since the outbreak of the crisis, in the sense that
on the day in which tensions from the US sub-prime mortgage market first spilled over to
euro money markets, the ECB reacted quickly by temporarily offering unlimited amounts of
liquidity to the banking sector, to avoid that liquidity tensions would spill over to other
segments of the financial markets and to maintain control over short-term unsecured interest
rates. More recently, the decision to phase out, or to introduce new non-standard measures,
was also taken in accordance with what was judged to be appropriate under the market
conditions that prevailed at the time.
The Eurosystem's response has also been targeted. Our response has, for example, focused
on the banking sector, because this sector continues to play a major role in euro area
financial markets, in particular for the transmission of monetary policy.
Finally, the ECB has repeatedly emphasized the temporary nature of its non-conventional
measures. Indeed, maintaining measures which have outlived their usefulness for too long
could trigger other types of imbalances which could contribute to a new crisis in the future.
For example, if support for the banking sector is provided for too long, banks' incentives to
resume market-based funding activities may suffer and markets may become increasingly
dependent on central bank funding. Incentives for banks to monitor each other may also be
lost, and this could result in further market inefficiencies. For these reasons, the Eurosystem
tries to keep its interventions in financial markets at a low level that is still commensurate with
its main objective. This is the so-called market principle.
The Eurosystem will eventually also have to face the challenge of timing the process of
phasing out its non-conventional policies appropriately. When the time comes, it is important,
in my view, that our approach to monetary policy implementation is adapted in a gradual
manner to normalizing market conditions. This will allow the central bank to better fine-tune
its exit steps, and to ensure that the withdrawal of its support measures does not lead to
renewed market tensions.
Once market conditions have improved to the point at which the monetary policy
transmission mechanism can function without additional central bank support, monetary
policy implementation will be able to revert to a more conventional format. I would like to
emphasize, however, that the decision to scale back the non-standard measures can be
taken separately from any decisions on the level of interest rates that are set by the ECB.
In a gradual phasing-out, the ordering of different steps will need to be defined carefully, and
in line with market developments. When the time comes, the Eurosystem will also need to
define clearly what the appropriate design of the operational framework in a post-crisis world
should be.
In the years, before 2007, the framework performed very well, as it was able to achieve
stable short-term money market rates close to the minimum bid rate of our main refinancing
operations. This was achieved with a relatively rules-based implementation framework that
did not require frequent ad-hoc interventions by the Eurosystem.
Would the same framework achieve equally good results in a post-crisis environment? This
will depend on whether the financial landscape will change in ways that are important for the
transmission of monetary policy. I would like to mention a few possible developments.
First, as the annual ECB money market surveys show, wholesale interbank unsecured
lending activity has declined during the financial crisis. It is possible, that unsecured lending
will continue to account for a low share of overall lending in the interbank market, also in the
years to come. This could affect monetary policy implementation in two ways: first, the
steering of short-term unsecured rates constitutes the first step of the monetary policy
transmission mechanism. This mechanism might be weakened, should unsecured interest
rates become less relevant in determining overall access to credit. Second, it could lead to
more volatility in this market and thus make the steering of interest rates less precise. One
possible hypothetical response to such developments could be that central banks give
greater prominence to secured and repo market rates.
As a second possible development, market participants may retain a higher level of risk
aversion than was the case before the crisis. This could lead to higher risk premia and
continued market tiering. Lending rates in the money markets may also become more
dispersed, depending on the credit quality of the bank that is borrowing. This would render
the task of the central bank more complex.
Finally, the interaction between the new Basel III liquidity standards and monetary policy
operations is likely to be significant and complex. Central banks' policies can influence the
ability of banks to comply with the new liquidity risk regulation, because this regulation is
likely to affect banks' recourse to the central bank's operational framework. For instance, in
jurisdictions where the set of assets eligible for central bank operations is broader than the
one qualifying for the fulfilment of the liquidity standards, one may witness an increased
reliance on central bank refinancing using less liquid assets as collateral.
The question of whether central bank operational frameworks should support, or not, the
fulfilment of banks regulatory liquidity standards is certainly not straightforward. The
interaction between liquidity regulation and central bank operations will certainly be
pervasive. Indeed, central banks are by definition the only agents which are not affected by
liquidity risk and which generally continue to be considered free from default-risk during a
financial crisis. For these reasons, and as they fulfil a public mandate, central banks act as
lenders of last resort in financial crises, providing liquidity to the banking system in their
jurisdiction. Liquidity regulation is about ensuring that banks remain liquid also in a stress
situation to avoid the negative externalities of liquidity hoarding and the fire sale of assets.
Therefore, the lender of last resort function and liquidity regulations in some way share the
same goal, although none of them can by themselves be considered sufficient to address the
issue of financial instability caused by liquidity stress. They will also interact in the sense that
banks will factor in both liquidity regulations and the last resort function in their optimisation
behaviour. The two must therefore not be treated in isolation.
The possible impact of the new liquidity standards on central bank operations and related
relevant market segments (including those relevant for the transmission of monetary policy)
is currently being analysed carefully by the ECB.
5. Conclusion
To sum up, the financial crisis has brought many challenges for central banks in general, and
for the ECB in particular. More specifically, the conduct of monetary policy had to take into
account an increasingly large number of uncertainties while liquidity management by the
central banks had to adjust flexibly to implement monetary policy decisions in an
environment of distorted money market segments.
The flexibility of the Eurosystem's operational framework has proved invaluable during the
crisis, and it will allow the Eurosystem to adjust, if necessary, to a possibly change in the
financial landscape.
Of course, the recent sovereign debt crisis in some euro area counties poses additional
challenges, also for the Eurosystem. In this regard, it is essential that prudent fiscal and
economic policies are employed in all euro area countries. This will reduce bank's current
over-reliance on central bank funding and facilitate the ECB's task of delivering price stability.
In this context, I would like to emphasize that the central bank must remain vigilant in order to
ensure that its enhanced intermediation role during crisis times is not abused by fiscal
authorities and market participants, as it remains essential that they strictly fulfil their own
responsibilities. This approach means that market participants must also adopt a pro-active
liquidity management policy and accept trading with each other again. It also implies that
different public authorities, like regulators and governments, should also take the necessary
measures to stabilise the financial system, so that it can play its part in the recovery of
activity and employment.
Thank you for your attention.
References
Cassola, N., A. Durré and C. Holthausen (2010): "Monetary Policy Operations - Experiences
during the crisis and lessons learnt", in Approaches to Monetary Policy Revisited -
Lessons from the Crisis, Proceedings of the Sixth ECB Central Banking Conference,
18-19 November 2010, p 280-321.
Eisenschmidt, E. and C. Holthausen (2010): "The minimum liquidity deficit and the maturity
structure of central banks' open market operations: lessons from the financial crisis",
European Central Bank Working Paper 1282.
Gray, S. (2011): "Central bank balances and reserve requirements", IMF Working Paper
WP/11//36.
Marqués-Ibáñez D. and L. Gambacorta (2011), "The bank lending channel: lessons from the
crisis", Economic Policy 26, 66, 137-182.