Peter Praet: Ensuring price stability
Remarks by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the Belgian Financial Forum colloquium on "The low interest rate environment", Brussels, 4 May
2017.
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Accompanying slides.
I would like to thank Leopold von Thadden for his contribution to this speech.
The cyclical recovery of the euro area economy is becoming increasingly solid and downside
risks to the growth outlook have further diminished. Today the configuration of risks around the
most likely growth outlook is closer to balance than it has been in some time. Yet, downside risks
still prevail, being mainly related to remaining fragilities in the global outlook. Also, despite the
cyclical recovery, underlying price pressures remain subdued as unutilised resources continue
to weigh on domestic wage and price formation. As yet the evidence continues to indicate
insufficient progress towards a sustained adjustment in the path of inflation towards levels below,
but close to, 2% over the medium term, which is a condition we have indicated for the ECB to
start a gradual process of normalisation in its monetary policy stance. In view of this evidence,
the Governing Council in its April meeting has judged that the complex set of instruments that we
have put in place over the past three years to counter downside risks to price stability, including
our forward guidance, is still needed to support a durable and self-sustaining inflation
convergence. After a prolonged period of exceptional monetary policy accommodation, any
change in our policy stance should be gradual. It should be motivated by sufficient evidence that
the present indications of an acceleration in activity find confirmation in hard data and that a more
robust growth feeds through into a sustainable adjustment in the path of inflation.
What are the conditions that led to the adoption of this complex package of monetary policy
measures? And how can we measure their success in fostering progress in our economy, as a
pre-condition for a lasting return of inflation to levels more consistent with our objective of price
stability over a medium term horizon? Let me first lay out the strategy that we followed over the
past challenging years since the collapse of Lehman in 2008 to counter a deeper and more
damaging economic contraction and ward off risks of deflation and of a prolonged period of
below-norm inflation. What I will refer to as the three phases of the crisis have called for the
deployment of different policy instruments, so I will start establishing a correspondence between
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the chronology of the crisis and the taxonomy of our instruments. I will then turn to the current
state of the economy to extract inferences about the effectiveness of our strategy. I will then
conclude looking forward.
Monetary policy responses to the crisis
In the euro area, the crisis has evolved through three phases. The first phase was triggered by
the abrupt liquidity strains that almost paralysed the global financial system in the immediate
aftermaths of the collapse of Lehman Brothers. Banks - both in the euro area and elsewhere -
suddenly became very uncertain about the underlying health of other banks and stopped lending
to each other. The ECB was very swift in its response, faithful to its responsibility to guarantee
appropriate liquidity conditions to solvent banks. Together with other major central banks, the
ECB stepped in with forceful and coordinated interventions to provide essential liquidity to the
banking sector. In the euro area, liquidity was made available in virtually unlimited amounts -
against eligible collateral - and at increasingly longer tenors, which helped those banks that were
being negated access to market refinancing to remain in business and continue their key
intermediation function. Without this response, the financial system would have imploded and a
far deeper contraction would have occurred.
The second phase of the crisis came as a consequence of the loss of confidence in some
sovereigns. It brought on the development of redenomination risk and thereby threatened the
integrity of our currency. The sovereign debt crisis found impulse in some cases from a weak
fiscal position, whereas in others from a weak banking system. But irrespective of its initial
impulse it quickly became a two-way interaction through the "bank-sovereign" nexus. Banks
remained dependent on fiscal authorities for solvency assistance, and the financial obligations
vis-à-vis banks that this responsibility created on the side of some national fiscal authorities with
weak fundamentals further undermined their credit standing. As the cost of borrowing for certain
governments increased, banks with exposures to this debt came under intense market pressure,
ultimately leading to entire national banking systems losing market access. This in turn resulted
in financial fragmentation and a serious disruption to the monetary transmission mechanism.
The ECB had not remained inactive in the face of such vicious feed-back loop, as it saw the
implications that such dynamics could have for price stability. But, as the ECB lowered interest
rates, these reductions were not being passed on to firms and households in a large part of the
euro area, signalling an unusual disconnect between expanding central bank liquidity,
exceptionally stimulative monetary policy interest rates and contractionary loan dynamics to
NFCs and households.
The ECB then responded to these unprecedented conditions with a twofold reaction.
First, the ECB revived the longer-term refinancing instrument that had proven particularly
effective in the aftermaths of the Lehman demise. Central bank liquidity was made available to
banks for up to three years. This eased the pressure particularly on banks located in the
jurisdictions that had been hit by the sovereign debt crisis.
Second, the announcement of Outright Monetary Transactions (OMT) in the summer of 2012
removed the euro area break-up risk which markets - by that time - had started to price into the
yields of securities issued by the governments most impaired by the sovereign debt crisis. The
impact of the announcement on market sentiment was instantaneous and material to an extent
few had anticipated. The steep fall in interest rates and improved monetary policy transmission in
those countries most affected by the sovereign debt crisis averted a deeper recession in the
euro area as a whole. Nonetheless, the sovereign debt crisis left a damaging legacy on the euro
area economy and laid the groundwork for the third phase of the crisis.
In the subsequent years, the trauma that the debt crisis had caused for the banks located in the
vulnerable countries triggered among those banks a drawn-out process of deleveraging aimed at
shedding the most risky components of their balance sheets: loans to the economy. This, once
more, impeded transmission of the stimulus introduced by OMT and by the liquidity operations to
the real economy and threatened to derail the very tenuous recovery that had started in 2013.
The third phase of the crisis started in 2014, as it became clear that the incipient recovery was
too fragile and dependent on progress in transmission to warrant inaction on the side of the ECB.
Additional monetary policy measures were required to repair the bank lending channel and to
arrest the accelerated decline in both headline and underlying measures of inflation that had
become visible since early 2013. While inflation had started to drift downwards, there was a
palpable risk that the disinflationary pressure would de-stabilise long-term inflation expectations
and usher in a self-sustained period of deflation.
As the main policy interest rate, the interest rate on the deposit facility, had already been brought
to zero in summer 2012, the Governing Council introduced innovative measures to provide
additional stimulus. Starting in June 2014, the Governing Council brought the interest rate paid on
banks' deposits of excess liquidity with the Eurosystem to -0.1%. At the same time, a credit
easing package was announced which included targeted longer-term refinancing operations
(TLTROs I), a programme to purchase covered bonds issued by the banks (CBPP3, a new
version of two earlier programmes with a similar scope) and a novel asset-backed securities
purchase programme (ABSPP).
Generally speaking, credit easing measures influence the economy via three main transmission
channels: direct pass-through, portfolio rebalancing and signalling. All three channels supported
the key motivation underpinning the design of this package, namely to improve the pass-through
for liquidity injected into the financial system to private sector borrowing costs and to reinforce
the accommodative monetary policy stance.
The credit easing measures were immediately effective in turning around the credit crunch
situation prevailing in a number of countries and favouring a pronounced easing in bank lending
conditions for companies and households. But, also due to the headwinds coming from the
international economy, the inflation outlook continued to deteriorate in the summer and in the
autumn of 2014 and long-term inflation expectations started to give concrete signs of
destabilisation. As a result, in January 2015 the Governing Council announced the expanded
asset purchase programme (APP), which included a large-scale purchase programme targeting
public securities (PSPP).
The purpose of the new programme was to reinforce the direct path-through effects generated
by CBPP3 and ABSPP by promoting a general compression of yields across all asset classes.
This in particular brought about extra incentives for banks to rebalance their portfolios towards
assets with higher risk-adjusted returns, such as loans to firms and households.
Overall, these measures have been designed to complement each other and have proved
effective and adaptable to the series of shocks which have hit the euro area economy since their
introduction. Indeed, the deposit rate has been reduced further (now standing at -0.4%). This
decrease into more negative territory incentivises banks to invest the liquidity they receive as a
consequence of the asset purchases into longer-maturity and higher yielding assets. The APP
has been recalibrated since its introduction and in early 2016 the Governing Council announced
four additional targeted longer-term refinancing operations (TLTROs II) to further support credit
availability to euro area firms and households.
All these elements adopted in the third phase are still in place. Moreover, the ECB has adopted
an integrated system of forward guidance that governs the future path of asset purchases and
short-term interest rates, as well as the sequencing of these different policy tools. I will come
back to this at the end of my talk.
The cyclical recovery in the euro area is becoming increasingly solid
Our monetary policy works and the effects of our measures on the euro area economy are
becoming increasingly visible. Euro area real GDP has expanded for 15 consecutive quarters,
with the quarterly growth rate for the final quarter of 2016 standing at solid 0.5%. For the first
quarter in 2017, according to Eurostat's preliminary flash estimate, the same quarterly growth
rate of 0.5% can be expected. This suggests that the economic expansion is likely to have firmed
and broadened in the first few months of this year. The euro area composite PMI output, in
particular, hit in April a six-year high, signalling a strong start to the second quarter.
While the optimistic picture inspired by recent soft data still awaits validation in hard data
releases, we take comfort in the fact that euro area growth seems increasingly robust to adverse
overseas influences, as domestic factors have become key drivers of the on-going economic
expansion. This is a crucial difference to earlier, abortive recoveries. Robust employment growth
continues to strengthen households' labour income and to support consumption. The euro area
unemployment rate stands at its lowest level since April 2009. Private consumption has been a
main driver of growth throughout last year, expanding in 2016 at an annual real rate of 2%.
Reflecting a more synchronised upswing across economic regions on a global scale,
international trade has picked-up recently at a rather strong pace which should further support
the euro area recovery.
It is also comforting to see the euro area recovery broadening across countries, sectors and
labour markets. If one looks at the percentage of all sectors in all euro area countries that have
positive growth, the figure stood above 80% at the end of last year, well above its historical
average of 73% and the level observed during the 2009-11 recovery. Similarly, the dispersion in
growth rates across both sectors and countries has also narrowed significantly and both are now
at their lowest level since 1997. The same evidence is visible for employment. Just as for GDP
growth rates, the dispersion of employment growth across euro area countries is now at record
low levels.
The fact that the cyclical recovery is becoming increasingly solid reflects the effectiveness of the
various monetary policy measures - both standard and non-standard - that have been
undertaken by the ECB, in particular since mid-2014. Our policy has not only eased financing
conditions on average, but triggered a remarkable convergence in borrowing costs across
different euro area countries. Non-standard measures are estimated to be particularly effective in
counteracting bank funding and financial fragmentation in some jurisdictions. This is reflected
also in the lending conditions faced by the real economy. In June 2014 the median lending rate
for firms in vulnerable economies was 120 basis points higher than for those in stronger ones -
despite overnight rates being close to zero. Today the difference is only 20 basis points.
These improvements have led to rising credit volumes and improved access to finance,
especially for small and medium-sized enterprises. Loan growth has proceeded along a path of
gradual recovery since 2014. And across financial intermediaries, the banks which participated in
the TLTROs have experienced higher loan dynamics than the non-participating ones.
Modelbased analysis indicates that the contribution of non-standard measures to the annual loan
growth to NFCs is in the order of 2 p.p. at the current juncture, and should remain supportive
going forward.
This assessment is corroborated by the ad hoc questions of the Bank Lending Survey on the
impact of APP, negative DFR and TLTRO which point to significant easing effects of the
measures on broad credit conditions, despite some restraints on bank profitability.
The Bank Lending Survey also shows that euro area banks have reacted to the package of
measures by easing significantly the terms and conditions that they offer on loans. It is
interesting to delve into the factors that banks cite to explain the change in their lending
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behaviour . While heightened "risk-perceptions" and low capacity by banks to "tolerate risk"
were consistently mentioned by banks as two key factors contributing to tighter credit standards
throughout what I referred to as the third stage of the crisis, the last three years have seen an
evolution in the composition of factors explaining the changes in credit standards. Whereas the
unwinding of "risk perceptions" has offered a material contribution to the easier credit standards
that we have observed since 2014 (with only a slight reversal in the most recent period), "risk
tolerance" has remained moderate and, in fact, since 2015 has even tended to offset the easing
impulse coming from other factors. This can be interpreted as evidence that, despite a
turnaround in the market for bank credit and in the general economic prospects more broadly,
banks continue to apply prudent standards when deciding whether to extend new credit. This
being said, taking a longer term perspective, the ad hoc question on the level of credit standards
indicates that credit standards are tighter today than in the pre-crisis period, and since 2010 have
eased only to some extent and in some jurisdictions.
The monetary impulse from non-standard measures is also reflected in broad monetary
dynamics. Evidence on the sectoral allocation of the ECB's asset purchases, and on portfolio
rebalancing decisions towards monetary instruments, would indicate that current M3 growth is
significantly supported by the APP. The support of central bank liquidity to broader monetary
aggregates is further vindicated by the growing contribution of households and firms deposits to
M1 and M3 growth. Judging from their leading indicator properties on economic activity, this
might also bring some confidence on the strength of the underlying economic recovery.
Underlying inflation dynamics remain subdued
Is macroeconomic repair complete? I would not conclude in this direction.
First, while the drag on domestic activity from abroad - which was considerable in certain stages
of the crisis - has largely faded, and while global data and indicators point to sustained
momentum in activity and trade early in 2017, the ongoing synchronised recovery is still
depending on a high degree of policy support. And even if on the upside there is a possibility that
stronger sentiment in financial markets and confidence indicators translate into a faster pick-up
in activity than currently foreseen, risks to the global economy over the medium term are stacked
to the downside and weigh on euro area prospects. These relate to re-escalating geopolitical
tensions, the possibility of a less favourable resolution of some remaining fragilities in key EMEs,
particularly China, as well as questions related to Brexit and the future policy choices of the US
administration.
Second, most importantly, the strengthening of economic activity has yet to find correspondence
in inflation developments: underlying inflation and domestic price pressures remain subdued.
Headline inflation has been exceptionally volatile over recent months. After a sharp rebound
between November and February, in March HICP inflation has dropped sharply to 1.5%, reflecting
lower inflation rates for all main components - energy, food and HICP excluding food and energy
- only to return to 1.9% in April, according to the Eurostat flash estimate of last week. Inflation
excluding food and energy for April is currently estimated to have reached 1.2%, up from an
almost all-time low of 0.7% in March. However, inflation is predicted to oscillate around one and a
half percent for the remainder of the year before resuming a gentle path toward levels closer to
2% in the following two years. Inflation stripped of the most volatile price components is also
expected to follow an upward path which should bring it to levels comparable with those of
headline inflation by 2019, but the trajectory is expected to remain slow. More sophisticated
measures of underlying inflation pressures have yet to show a convincing upward trend.
There is not yet sufficient evidence that the observed strengthening of producer price inflation at
the earlier stages of the pricing chain will be durably transmitted to later stages which matter for
HICP inflation. Annual global producer price inflation excluding oil remained elevated at 3.1% in
February, standing above its long-term average. Yet, further up the pricing chain, producer price
inflation for domestic sales of non-food consumer goods increased only slightly to 0.3% in March.
A clear sign of a turning point is not yet visible. One way to reconcile the increasing price
pressures at the earlier stages with weak producer price inflation of consumer goods is a
squeeze in margin. In any case, a lagged transmission of pipeline pressure up the pricing chain
would be in line with past observations.
Similarly, the GDP deflator, the broadest measure of domestic price pressures and one closely
linked with developments in underlying inflation, does not yet provide evidence of strengthening.
In the fourth quarter of 2016 the annual growth rate of the GDP deflator decreased further,
although mainly on account of a weaker contribution from unit taxes. A strengthening of unit
labour cost growth and profit margin growth can be a reliable signal that domestic demand is
exerting a material traction on inflation. From this perspective, profit margin growth has increased
in the last two quarters of 2016 after it had been depressed by the waning terms of trade effects.
By contrast, unit labour cost growth has been broadly flat.
This suggests that in order to achieve a sustained adjustment in the path of inflation wage growth
has to be stronger. This will require that higher employment levels not only reduce the slack in
labour markets, but also feed through into wage dynamics. At this juncture it is not easy to
predict how quickly this will happen. In particular, while the amount of slack plays a decisive role
for underlying inflation, there is high uncertainty around its measurement. A strengthening labour
market may attract "marginally attached" workers back into the labour force, or encourage those
"underemployed" to seek more hours, causing the effective supply of labour to rise in tandem
with demand. Due to such effects, measures of labour underutilisation which are broader than
the recorded unemployment rate would have predicted lower inflation in the last two years and
thereby offered a better account of observed inflation outcomes than more traditional Phillips
curve specifications. In view of this evidence domestic wage pressures may therefore only
materialise at a relatively late stage in the economic expansion.
Mirroring still weak domestic price pressures, market-based inflation expectations have failed to
correct in a sustainable manner and continue to suggest only a very slow adjustment towards
2%.
Appropriateness of the current very accommodative monetary policy stance
In view of currently available evidence, the Governing Council in its April meeting has judged that
there is not yet sufficient evidence of progress towards a durable and self-sustaining
convergence in the path of euro area inflation that would warrant a scaling back of the
exceptional degree of monetary policy accommodation. For us to conclude that a self-sustaining
convergence in the path of inflation is accomplished, we will not only need to build confidence
that inflation is on an upward path reaching levels close to 2% within a meaningful medium-term
horizon. We will also need to verify that inflation is sufficiently robust to a firming of policy. In other
words, inflation would need to maintain its trajectory even with diminishing support from
monetary policy. In this context it should be recalled that the latest ECB staff projections from
March this year include a material contribution from monetary policy to the path of inflation.
In sum, continued monetary policy support for demand remains key to inflation convergence. The
recovery of inflation still depends on the very favourable financing conditions that firms and
households are facing, which in turn is largely due to the current very accommodative monetary
policy stance.
The forward guidance on the future course of our policy is an integral component of our stance,
as re-asserted by the Governing Council at its last meeting in April. The Governing Council's
forward guidance is structured around two fundamental elements: conditionality which links the
horizon of the APP to the sustained adjustment in the path of inflation consistent with our inflation
aim, and the sequencing which gives indications about the expected path of our key policy rates
during the life of our net asset purchases and beyond. These fundamental features of our
forward guidance have a clear logic. They are meant to communicate that our set of measures
will evolve over time in a way that can most efficiently internalise and exploit the intimate
complementarities among the various instruments, notably the asset purchases and the negative
rate policy. All other features of our forward guidance are of a parametric nature and can be
recalibrated depending on incoming data.
Looking forward to our next monetary policy meeting in June, we will be able to draw on a more
expanded information set than is available today, organised around new projections and including
an updated assessment of the distribution of risks surrounding the economic outlook.