BANCODEESPANA

Eurosistema

20.03.2024

Monetary Policy Transmission and the Banking System
The ECB and Its Watchers
Frankfurt

Pablo Hernandez de Cos
Governor


I would like to thank the Institute for Monetary and Financial Stability and the Goethe
Universitat for inviting me to take part in this event, thus giving me the opportunity to share
with you some reflections on the transmission of monetary policy through the banking
system during the current hiking cycle.

I will start by summarising some features that could have potentially altered the strength
and speed of the monetary policy transmission mechanism in the euro area in comparison
with previous tightening cycles. I will then focus on the evidence we have on how monetary
policy has been transmitted during the last two years to financial conditions and, ultimately,
activity and prices.

Specific features of the current monetary policy tightening cycle

PARTICULARITIES OF THE CURRENT MONETARY POLICY TIGHTENING CYCLE

STRUCTURAL CHANGES IN + Banking sector: better capitalization, higher liquidity ratios and higher concentration in the sector wi
THE BANKING SYSTEM

+ Debt burden less sensitive to interest rate changes (py
STRUCTURAL CHANGES IN
THE FINANCING OF FIRMS * Higher gross debt to income ratios of households [/f ]

AND HOUSEHOLDS - -
Shift from bank to bond funding (t)

VERY ACCOMMODATIVE + Interestrates at negativeterritory [J #]

'STARTING POSITION , re '
High levels of excess liquidity in the banking system Ip

HOUSING MARKET STARTING . _. .
POSITION + Signs of overvaluation in some countries [¢]

THE ORIGIN OF THE
INFLATIONARY SHOCK + Great role of adverse supply shocks: bottlenecks and energy shock [q]

THE SPEED AND INTENSITY

OF THE TIGHTENING + Interest rates have risen 450 bps between July 2022 and September 2023 it in case of non-linear effects]

t potentially stronger transmission of the monetary policy tightening

y potentially weaker transmission of the monetary policy tightening

The first factor that could have potentially altered the strength and speed of the monetary
policy transmission mechanism in the recent tightening process is related to structural
changes in the euro area banking system. Banks are now better capitalised and display
higher liquidity ratios than in the past. This is mostly attributable to new regulations
introduced after the global financial crisis. Additionally, there has been an increase in the
degree of concentration in the banking sector.! And the economic literature suggests that
greater concentration in the banking sector and the existence of healthier banks tend to
weaken the monetary policy transmission mechanism.?

' For instance, the average share of assets held by the five largest banks in the euro area has risen from 60% in 2008 to
68% at the end of 2022. For further details, see EU structural financial indicators: end of 2022.

? In particular, better capitalised banks are able to obtain funding at lower costs and to absorb potential losses associated
with the tightening of monetary policy and, as a consequence, can grant more loans and at a lower price (see Altavilla,
C., F. Canova and M. Ciccarelli. (2020). "Mending the Broken Link: Heterogeneous Bank Lending Rates and Monetary
Policy Pass-Through". Journal of Monetary Economics, vol. 110, pp. 81-98, Holton, S., and C. Rodriguez d'Acri. (2018).
"Interest rate pass-through since the euro area crisis". Journal of Banking & Finance, vol. 96, pp. 277-291, or Gauvin, M.
S. (2014), "Bank Characteristics and Procyclicality: A Theoretical Approach", Journal of Financial Risk Management).
And the empirical evidence shows that banks operating in countries with higher levels of bank concentration increase


A second factor relates to the debt burden of the euro area non-financial private sector,
which has become less sensitive to interest rates hikes in the short term. Between
2012 and 2022, the share of households' bank debt with an interest rate fixation period of
up to one year fell from 35% to 24%, while for non-financial firms the proportion of bank
debt either maturing within a year or with an interest rate fixation period of up to one year
declined from 70% to 59%.° However, the gross debt to income ratios of households
are now higher than in the 2000 and 2005 tightening episodes, which would tend to
strengthen transmission.4

Third, there has been a shift from bank to bond funding over the last decade, with bond
debt increasing from 16% to 24% of non-financial corporations' total debt between 2012
and 2022. This, together with the faster monetary policy pass-through to bond rates than to
bank rates, implies faster transmission than in the past.

Fourth, when the ECB started to tighten its monetary policy, money market rates were in
negative territory and there was an excess of liquidity in the banking system. This very
accommodative starting position may have weakened the pass-through of market rates
to deposit rates. However, cutting rates to negative levels can compress term rates by more
than an equally sized cut from one positive level to another. This is because of frictions that
encourage investors to move along the duration and risk scale when interest rates are
negative. Symmetrically, raising rates from negative to zero or positive levels could also
have a disproportionate tightening impact on the term structure.>

Fifth, some euro area countries had experienced a significant increase in house prices over
the decade running up to the pandemic, with signs of overvaluation.* And housing
represents a major part of household wealth and bank assets. The tightening of monetary
policy may contribute to an adjustment in house prices, especially in countries with
stretched valuations. Thus, a potential decrease in house prices would weigh negatively on
household wealth, with a possible impact on consumption due to wealth effects.
Additionally, it would have a negative impact on banks' portfolios, by reducing the value of
the collateral provided to banks by households and firms, which might ultimately affect
credit developments.

Sixth, as regards the origin of the inflationary episode, adverse supply shocks, notably
bottlenecks and the energy shock that followed Ukraine's invasion by Russia, have played
a greater role this time. As a result, the tightening took place in a context of weak growth
and high uncertainty, which may have contributed to amplifying the tightening of financing
conditions through higher risk premia and tighter credit standards. But, of course, the

deposit remuneration to a lesser extent and offer bank credit at lower costs (see Mayordomo and Roibas (2023), "The
pass-through of market interest rates to bank interest rates", Banco de Espajfia, or Van Leuvensteijn, Sorensen, Bikker
and Van Rixtel (2013), "Impact of bank competition on the interest rate pass-through in the euro area", Applied

Economics).

3 These results, however, mask a significant degree of heterogeneity across countries.

4 See "The banking channel of monetary policy tightening in the euro area". Philip R. Lane, at the Panel Discussion on
Banking Solvency and Monetary Policy, NBER Summer Institute 2023 Macro, Money and Financial Frictions Workshop,
July 2023.

5Advance communication of an imminent hike can attenuate this threshold effect. See, Altavilla et al (2021): "Combining
negative rates, forward guidance and asset purchases: identification and impacts of the ECB's unconventional policies",
ECB Working Paper Series No. 2564.

® See the ESRB reports on "Vulnerabilities in the residential real estate sectors of the EEA countries".


opposite might have been true when the reversal of the surge in energy prices and the
easing of supply chain bottlenecks took place.

Finally, the current tightening cycle has been unprecedented both in terms of its
magnitude and speed. Between July 2022 and September 2023 (i.e. in 14 months) policy
rates rose by 450 bp and were accompanied by a significant reduction in our balance sheet.
The possible existence of non-linearities, in particular those related to the deterioration of
private sector balance sheets, could have strengthened the transmission.

How has the ECB's monetary policy been transmitted to financial conditions?

BANCODEESPANA

COST OF NEW LOANS TO HOUSEHOLDS AND NON-FINANCIAL FIRMSIN THE CUMULATIVE CHANGE IN EURO AREA BANK INTEREST RATES FROM
EURO AREA (a) DECEMBER 21 TO DECEMBER 23(a)
g
5
8
7 4 z
6
3
5
I . L }
3
1
2
1 °
Jan-22 Apr-22 Juk22 Oct-22 Jav-23° Apr-23 Juk23 Oct-23 HO.ISE TIME DEPOSITS CREDIT TIME DEPOSITS

PURCHASE
HOUSFHOI Ns. NON-FINANCIAL FIRMS.

MOBSERVED * ESTIMATED ACCORDING TO PREVIOUS CYCLE (0) ~95

ONFIDENCE INTERVAL

SOURCES: European Central Bank and Banco de Espafia

'a. Narrowly defined effective rates (NDER) adjusted for seasonality and the irregular component.

. Bank interest rate that would resuit if the increase in the market interest rate in the current cycle had been passed through in a similar way to that recorded in the previous cycle as estimated by
standard error correction models forthe period January 2003 - August 2007

As to what has actually happened during this hiking cycle in terms of transmission, and
focusing on the banking sector, the evidence so far shows the following stylised facts:

First, since December 2021, when the tightening cycle began, up to the present, the pass-
through of higher market rates to the remuneration of time deposits has been weaker
than would have been expected on the basis of historical regularities. Specifically, the
cumulated increase in time deposit interest rates observed in this cycle has been around
100 bp and 20 bp lower for households and non-financial corporations, respectively, than
the historical regularities of past hiking cycles would have suggested.

Based on the analysis of data from a pool of around 100 European banks, we find that this
weak pass-through could be attributable to banks' reduced funding needs to support their
lending, given ample liquidity and weak credit demand.' The greater concentration in the
banking sector also contributed to the weakness of the pass-through. And the fact that the
remuneration of deposits was above market interest rates at the beginning of this cycle,
reflecting banks' reluctance to reduce it into negative territory during the expansionary
monetary policy phase also played a role. In particular, it may have led credit institutions to

' For more details on the potential drivers of the pass-through to deposit and mortgage rates over the period December
2021 - December 2022, see Mayordomo and Roibas (2023), "The pass-through of market interest rates to bank interest
rates", Banco de Espafia


delay the increase in deposit remuneration until the spread over market rates turned
negative.

Second, the average increase in interest rates on new loans for house purchase has
been in line with historical patterns. However, in this case, it was found that banks whose
total deposit remuneration had risen the least over the reference period and banks that were
better capitalised passed through the increase in market interest rates to their mortgage
rates to a lesser extent.

In the case of new loans to non-financial corporations, the pass-through has been
more intense. In particular, the cumulated increase has been 50 bp higher than what would
have been expected given past hiking cycles. This could be related to the weaker
macroeconomic environment and higher uncertainty in the current cycle, shaped by a
sequence of supply shocks, compared to past tightening episodes, resulting in higher credit
risk premia.

MONETARY POLICY TRANSMISSION TO CREDIT STANDARDS AND NET CREDIT FLOWS HAS

ALSO BEEN STRONGER THAN IN OTHER TIGHTENING EPISODES

CHANGE IN EURO AREA BANK LENDING STANDARDS (a)

LOAN PROJECTIONS (YoY). SPANISH NON-FINANCIAL FIRMS (b)

TGHTENNG

EASING

TONON-FINANCIAL  TOHOUSEHOLDS FOR CONSUMER CREDIT AND
FIRMS HOUSE PURCHASE OTHER LENDINGTO
HOUSEHOLDS

Nov-22 Mar-23 Juk23 Nov-23

INTEREST RATE HIKING

"GLOBAL FINANCIAL

2006 03

= SOVEREIGN DEBT CI
Ss INTEREST RATE HIKING ce DEC-23

SOURCES: European Central Bank and Banco de Espafia
'a. Average ofthe net percentage forthe coresponding period (percentage of banks reporting a tightening less percentage of banks reporting an easing).
b. Inall forecasting exercises the explanatory variables are those observed at December 2023.

Third, credit standards have tightened significantly since 2022, in contrast to the slight
easing observed in the tightening cycle of 2005-2006. The tightening has also been more
severe than during the sovereign debt crisis, although not as sharp as during the global
financial crisis.

The contraction in credit supply during the current tightening cycle is mainly attributable to
the greater risk perceived by lenders, associated with the weak macroeconomic outlook,
together with a deterioration in banks' perceptions of borrowers' creditworthiness. These
factors are related to the negative supply shocks observed in this cycle, in contrast to the
positive demand shocks that predominated during the 2005 monetary policy tightening
cycle.

In addition, banks' cost of funds and balance sheet constraints have also contributed to the
tightening, although to a lesser extent. According to recent research conducted at the


Banco de Espajia,® less capitalised banks have tightened their credit standards on loans to
firms to a greater extent in the current hiking cycle. This can be explained by poorly
capitalised banks having lower loss-absorption capacity than well-capitalised banks,
meaning that they may not be able to take on additional risks.

Fourth, the tightening in credit standards, coupled with lower demand for funds, has
resulted in a marked slowdown in credit flows, which, since end-2022, has been more
intense than historical regularities would have suggested.

Indeed, in recent years, credit developments have repeatedly surprised on the downside
compared to projections based on historical patterns. In this regard, research conducted by
the Banco de Espafia shows evidence of non-linear effects of the transmission of monetary
policy to credit standards for loans to non-financial corporations due to the unprecedented
intensity of the increase in interest rates. ECB analysis also shows that a non-linear model
taking into account not only the overall size of the rate hikes but also the size of rate hikes
per unit of time gives a much better fit when trying to replicate the observed loan creation
developments.'°

THE HISTORICAL RELATIONSHIP BETWEEN THE CREDIT QUALITY OF LOANSAND INTEREST _szancopeespr

RATES SHOWS SOME EVIDENCE OF NON-LINEAR EFFECTS IN SPAIN

However, these effects are only sizeable for very high increases in interest rates or, especially, when the increase takes place under
an adverse macroeconomic scenario.

Household mortgages. Spain Loans to SMEs. Spain

(PP)

Cumulative increases in PD

+50 +100 +150 +200 +250 + 300 + 350 +400 + 450 + 500 + 550 + 600 +650 + 700 +50 +100 + 150 + 200 +250 + 300 + 350+ 400 + 450 + 500 + 550 +600 + 650+ 700

Inen in Euribor

Source: Banco de Espatfa.

Notes: The charts present the probability of loans transitioning from normal situation to doubtful (PD) as a function of the level of the 12-month Euribor reference rate. The PD is modelled with an
autoregressive logit specification with macro-financial controls, as in the top-down stress test model of Banco de Espafia (FLESB). The estimation sample comprises loans of significant institutions.
Under the baseline scenario, macroeconomic variables other than interest rates are fixed at values in line with baseline macroeconomic forecast, whether under the adverse scenario, they are fixed
at stressed levels in line with the 2023 FLESB and EBA stress test exercises. Household mortgages refer to loans to physical persons with housing present as real guarantee, whereas loans to
'SMEs refer to loans to firms that qualify for this definition in sectors of activity other than real estate development and construction.

Fifth, in terms of the impact on the financial vulnerability of households and firms, as
expected, the increase in interest payments associated with the increase in interest rates
has been more pronounced in euro area countries with a strong prevalence of floating
rate contracts or short-term loans in the stock of mortgages and corporate debt, such as
Spain and Italy."1 The SAFE (Survey on access to financing by enterprises) also shows that

8 See Garcia-Posada, M. and P. Paz (2024), "The transmission of monetary policy to credit supply in the euro area",
mimeo.

° See Garcia-Posada and Paz (2024), "The transmission of monetary policy to credit supply in the euro area", mimeo.
1° For further details, see "The banking channet of monetary policy tightening in the euro area". Philip R. Lane, at
the Panel Discussion on Banking Solvency and Monetary Policy, NBER Summer Institute 2023 Macro, Money and
Financial Frictions Workshop, July 2023.

11 For the euro area, the cumulated increase since December 2021 in the average interest rate on outstanding bank loans
has been 90 bp and 240 bp for households and firms, respectively. In Spain the cumulate increase in the average cost
of outstanding bank debt has been 230 bp and 270 bp for households and firms, respectively.


the financing gap of euro area firms (the difference between their financing needs and actual
financing) has widen measurably in the course of 2023.

In this regard, an analysis based on the historical relationship between the probability of
default on loans granted by Spanish banks and the level of interest rates shows some
evidence of a non-linear relationship between these two variables for both mortgages
and loans to SMEs.'? However, these effects are only sizeable for very large increases in
interest rates and, especially, when the increase takes place in an adverse macroeconomic
scenario. This latter condition has not been fulfilled in the current juncture in Spain.
Additionally, interest rates have risen significantly but not enough for the emergence of
sizeable non-linear effects.

NON-LINEAR EFFECTS ARE NOT GENERALLY FOUND USING RECENT GRANULAR DATA Lanett aka

Non-linear effects are only observed in the case of indebted households with income below the median, and are not very significant.

INCREASE IN THE PERCENTAGE OF INDEBTED HOUSEHOLDS WITH A HIGH INCREASE IN THE PERCENTAGE OF INDEBTED FIRMS UNDERHIGH FINANCIAL

INTEREST BURDEN DUE TO THE INCREASE IN INTEREST RATES IN SPAIN (a) PRESSURE DUE TO THE INCREASE IN INTEREST RATES IN SPAIN (b)

7 7

6 6

5 5

4 4

3 a 3

2 2

1 1

° o
50 100 150 200 250 300 350 400 450 500 550 600 50 100 150 200 250 300 350 400 450 500 550 600

Interest rate increases (op)
-TOTAL +--BELOW INCOME MEDIAN Sa ae Se
SOURCE: Banco de Espafia

Acomplementary analysis using micro data for Spain confirms the existence of a relatively
linear relationship between the increase in the share of financially vulnerable
households and firms and the rise in the interest rates in the current juncture,'* with the
exception of indebted households with below-median income, for which there is some
evidence of small non-linear effects once interest rates increase by more than 250 bp.

12 The PD is modelled with an autoregressive logit specification with macro-financial controls, as in the top-down stress
test model of Banco de Espajfia (FLESB). The estimation sample comprises loans of significant institutions (Sls). Under
the baseline scenario, macroeconomic variables other than interest rates are fixed at values in line with central forecast,
whether under the adverse scenario, they are fixed at stressed levels in line with the 2023 FLESB and EBA stress test
exercises. Household mortgages refer to loans to physical persons with housing present as real guarantee, whereas
loans to SMEs refer to loans to firms that qualify for this definition in sectors of activity other than real estate development
and construction.

'8 Simulations performed using data from the Spanish Survey of Household Finances (Banco de Espafia, 2020) for
households, and the Central Balance Sheet Data Office integrated database (CBI) of 2021 for firms. Households are
considered vulnerable when debt service costs exceed 40% of their income, whereas a firm is considered to be
vulnerable when its interest coverage ratio is below one. The interest coverage ratio is calculated as (GOP + financial
revenue) / financial costs.


STRONG INCOME GROWTH HAS SLOWED THE INCREASE IN THE PERCENTAGE OF SPANISH B

ESPANA
VULNERABLE HOUSEHOLDS AND FIRMS
CHANGE IN PERCENTAGE OF INDEBTED HOUSEHOLDS WITH A HIGH CHANGE IN PERCENTAGE OF FIRMS UNDER HIGH FINANCIAL PRESSURE IN
INTEREST BURDEN IN SPAIN BY INCOME QUINTILE (a) SPAIN (c)
es euanneae eae po (Geviationelathetotne 2016-2019 average)
8 7 6
6 aseeaee 5
" é cas 4
g J L_. 3
2
°
4
2 : eemecs
°
a
6 s o
8 - - - SS ERaRREEESeEEEREREETE 9
Total Ist quintle 2ndquintile Srdquintile 4th quintile. Sth quintile pia naa an sos - opi
MIMITIGATING EFFECT ASSOCIATED WITH THE INCREASE IN HOUSEHOLD INCOME (b)
I DUE TO THE INCREASE IN INTEREST RATES -OsSERVED DEVELOPMENTS
TOTAL CHANGE PECTED DEVELOPMENTS. WITH DEBT ROLLOVER & CONSTANT GOP
--BPECTED DEVELOPMENTS. WITH DEBT ROLLOVER & INCREASING GOP
SOURCE: Banco de Espajia.
a. Simulations performed using data from the Spanish Survey of Housenold Finances (Banco de Espajia, 2020). The interest burden is considered to be high when debt service ccsts exceed 40% of
household income. To approximate the 2023 data, a 466 bps increase in interest rates and 15.6% increase in household income is assumed from 2020.
b. Mitigating effect associated to the increase in household income over the change in percentage of indebted households with high interest burden due to the increase in interest rates.
¢.Simulations performed using data from the Central Balance Sheet Data Office integrated database (CBI) of 2022. A firm is considered to be under high financial pressure If its interest coverage ratio
is below one. The interest Coverage ratio is calculated as (GOP + financial revenue) / financial costs.

But there is also evidence that the strong growth in nominal income has slowed the
increase in the percentage of vulnerable indebted households and firms. In the case of
households, the strong increase in income reflects both the rise in nominal wages and the
favourable performance of employment, which has grown by more than we had expected".
In the case of firms, sound corporate earnings have also kept the increase in the percentage
of vulnerable indebted firms in 2023 at very moderate levels.

BANK LOAN QUALITY INDICATORS HAVE RECENTLY SHOWN A LIMITED MATERIALISATION OF

BANCODEESPANA

RISKS

NON-PERFORMING AND STAGE 2 LOANS TO HOUSEHOLDSIN SPANISH NON-PERFORMING AND STAGE 2 LOANS TO NON-FINANCIAL
BANKS (a)

CORPORATIONS IN SPANISH BANKS (a)

Dec-19 = 190
Dec-19 = 100

200

150
100
y " i F '
2 &§ &§ & &§ 5 § § § FHF Ft RRB 25 § &§ §& 5 5 § &§ § FF & F& BA
'PEER ea EE RS EER aE E eee eget egad ae ee
2325332353 223882 38 § 2258 2258 223582358
-NPLs stage 2 -NPLs -Stage2

SOURCE: Banco de Espafa.

a NPLs and Stage 2 loans refer to the gross carrying amount of troubled assets in deposit institutions' portfolios. Loans are classified as non-performing when they are in default (there are amounts.
more than 90 days past due) or when there are indications that the loan is unlikely to be paid (e.9. the equity of a firm is negative). Loans are classified as Stage 2 when their credit risk has
increased significantly since initial recognition, but they do not meet the requirements to be classified as non-performing. They generally include those with amounts more than 30 days past due.

Finally, as regards the impact on the euro area banking sector, the contained increase in
the financial vulnerability of households and firms is also reflected in the limited

'4 In the Spanish case, for example, according to estimates drawing on our Survey of Household Finances, the share of
vulnerable indebted households rose moderately, from 10.5% in 2020 to just 11.2% in 2023 Q3.


materialisation of credit risk, even if default rates and NPLs are increasing in some sectors
and customer segments, most notably for exposures to commercial real estate, SMEs and
consumer loans'.

As a result, credit risk still falls short of the deterioration that could be expected, based on
historical regularities, following a deteriorating economic outlook, higher interest rates and
increases in bankruptcies. In this regard, there is evidence that the build-up of credit risk on
banks' balance sheets has been dampened by banks pre-emptively rebalancing their loan
and securities portfolios towards safer assets.

The rise in interest rate margins, as a consequence of the interest rate increase, together
with the limited materialisation of credit risk has led to a recovery in banks' profitability and
banks have remained well capitalised.

All in all, these results suggest the lack of amplification mechanisms through the banking
system in the transmission of the tightening of monetary policy in the current cycle.

How have tighter financial conditions been transmitted to activity, employment and
prices?

WEAKER THAN EXPECTED GDP GROWTH BY ECB/EUROSYSTEM STAFF MACROECONOMIC PROJECTIONS, BUT BANCODEESPANA
LABOUR MARKET HAS SYSTEMATICALLY PERFORMED BETTER THAN EXPECTED

4-QUARTER AHEAD EURO AREA GDP AND UNEMPLOYMENT PROJECTION ERRORS

percentage points,
0,60

0,00

0,50

"2,00
Jun 21BMPE for Sep 21BMPEfor Dec 21 BMPEfor Mar22 BMPEfor Jun22BMPEfor Sep22BMPE for Dec22BMPE for Mar 23 BMPE for
2201 2202 2203 2204 2901 2302 2303 2904

--GDP PROJECTION ERRORS 2 UNEMPLOYMENT PROJECTION ERRORS

SOURCE: Europeen Central Bank.
a. The error is obtained as the difference between the observed GDP gowth and unemployment and that included in the comesponding ECB projection exercise from 4 quarters earlier.

As to the evidence on the second leg of our monetary policy, from financial conditions to
activity and prices, it is of course very difficult to assess in real time. However, some
available analyses are useful in order to make a preliminary assessment.

First, since the start of the current monetary policy tightening cycle, the Eurosystem staff
macroeconomic projections have systematically overestimated GDP growth and these

'8 In the Spanish case, the stock of Stage 2 household loans grew between end-2022 and 2023 Q1, but has fallen
thereafter. And non-performing household loans increased slightly between 2023 Q1 and 2023 Q3 (the latest available
data). In the case of loans to non-financial corporations, NPLs in banks' credit portfolios continued to fall, while Stage 2
loans picked up in 2023 Q3. In any event, the total stock of problem loans (NPLs and Stage 2 loans) to both households
and firms on banks' balance sheets fell slightly during the first three quarters of 2023.


downward surprises do not seem to be fully explained by errors in the technical
assumptions, including the changes in the stance of fiscal and monetary policy. In these
projections the impact of financial variables on activity and inflation is largely based on
historical correlations and linear models. Therefore, this evidence might be signalling a
stronger transmission of monetary policy to macroeconomic variables than in the past.

But, of course, we cannot rule out that other factors apart from monetary policy may explain
these systematic errors in the projections. And, in this regard, the labour market has
demonstrated remarkable resilience over the past two years, as illustrated by lower than
expected unemployment rates, compared to staff projections. Even though those
projections were directionally correct in predicting a slowdown in employment growth, the
latter has been much higher than expected, more than compensating for stronger than
expected increases in the labour force. The persistent underestimation of employment
growth could be attributed, at least to some extent, to labour hoarding by firms in a context
of a very tight labour market and an economic slowdown largely perceived as transitory.

In the case of inflation, Eurosystem projection errors were significant in 2022 but their
accuracy has significantly improved since the end of 2022. And projection errors have
been mainly related to surprises in energy commodity prices and global supply chain
disruptions"®.

TIGTHER FINANCIAL CONDITIONS HAVE TRANSMITTED MORE FORCEFULLY TO ACTIVITY AND  pancopeesPANA
ALTHOUGH NOT SIGNIFICANT TO) INFLATION THAN IN PREVIOUS CYCLES ON AVERAGE

TIME-VARYING IMPACT OF A 100 BPS SHOCK ON GDP OVER THE FIRST YEAR TIME-VARYING IMPACT OF A 100 BPS SHOCK ON HICP OVER THE SECOND YEAR

Year-on-year vesconseer ts

iy 2:

05 I 15

ee

SSS ss Soh oS MK FESS SS SSK SKS SM

mmm 68% Ol "- - CONSTANT COEFFICIENTS MEDAN mm 68% CI - CONSTANT COEFFICIENTS MEDIAN

SOURCE: Banco de Espaiia
NOTES: Impact of a 25 bps (non-systematic) monetary policy shock based on recursive estimates of a Structural VAR (SVAR) model extension from Brandt et al (2019). Structural shocks are identified
through sign restricions.

Second, Banco de Espafia evidence based on recursive estimates of the impact of (non-
systematic) monetary policy shocks by means of a structural VAR (SVAR) model shows that,
in the current tightening cycle, the transmission of monetary policy to GDP growth and
inflation would have been somewhat more intense than that observed - on average -

'6 Chahad, M., Hofmann-Drahonsky, A.-C., Meunier, B., Page, A. and Tirpak, M. (2022), "What explains recent errors in
the inflation projections of Eurosystem and ECB staff?", Economic Bulletin, Issue 3, ECB; Chahad, M., Hofmann-
Drahonsky, A.-C., Page, A. and Tirpak, M. (2023), "An updated assessment of short-term inflation projections by
Eurosystem and ECB staff", Economic Bulletin, Issue 1, ECB.


before this unprecedented tightening cycle. This is especially the case for growth,
whereas the evidence for inflation is less conclusive.'"

Conclusions

Allin all, the evidence I have presented today suggests that the transmission of the current
monetary policy tightening cycle to private-sector financing conditions has been
forceful and, in some cases, stronger than would be expected on the basis of historical
regularities. This reflects some specific features of the current tightening cycle, such as the
origin of the inflationary episode in adverse and longer-than-expected supply shocks and
the unprecedented intensity and speed of the hiking that seems to have given rise to non-
linear effects on the credit supply.

By contrast, there is no evidence of amplifications effects through the banking system
linked to the deterioration of private sector balance sheets. The strong growth in the
nominal incomes of households and firms seems to have limited the impact on credit risk.
The positive evolution of employment has played a crucial role in this regard. Also, the
implementation of Basel Ill reforms in the EU to all banks, regardless of their size, has
improved the liquidity and solvency position of EU banks, thus helping the banking system
to absorb and not amplify negative shocks.

As regards the second stage of monetary policy transmission, some of the available
empirical evidence might be signalling a stronger transmission to aggregate demand.
However, we have persistently underestimated employment growth and we do not find
conclusive evidence of a differential impact of our monetary policy on inflation in
comparison with previous tightening cycles.

This analysis confirms that a stronger than expected monetary policy impact remains a
downside risk to the euro area growth outlook, as mentioned in our last monetary policy
statement. Thus we shall be closely monitoring the materialisation of such risks and
calibrate accordingly the degree of monetary restriction, in particular in a context in
which our staff projections are currently anticipating a gradual return of inflation towards our
2% symmetric target in the medium-run and with the risks to the inflation outlook being, in
my view, balanced.

17 The in-house evidence is based on recursive estimates on the impact of (non-systematic) monetary policy shocks by
means of a Structural VAR (SVAR) model extension from Brandt et al (2021) "What drives euro area financial market
developments? The role of US spillovers and global risk", ECB Working Paper No. 2560 , identified through sign
restrictions.