Peter Praet: Maintaining price stability with unconventional
monetary policy
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at the
Council of the European Union, Brussels, 29 January 2018.
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Accompanying slides
I would like to thank F. Holm-Hadulla for his support in preparing this speech.
Responding to the crisis in the euro area
The crisis that erupted in 2008 sparked a sharp downturn in the global financial cycle. In the
preceding years, over-optimistic growth expectations had taken hold in a number of advanced
economies. Despite slowing productivity growth, agents overestimated future income growth and
borrowed against it, accumulating excessive levels of debt. At the same time, financial
liberalisation and deregulation encouraged financial leverage and rapid credit growth. The ten
years since that eruption has been a changeable period of deleveraging and de-risking, with a
number of different phases.
The first phase was the immediate liquidity crisis triggered by the turning of the global financial
cycle and the subsequent collapse of Lehman Brothers. Market funding came to a sudden stop
for many financial institutions. The ECB's response was to lower its main refinancing rate to the
then record low of 1% in May 2009, to expand the range of eligible collateral for our refinancing
operations and to provide liquidity elastically to the banking sector, at both increasingly long
durations and against a wider range of collateral.
The second phase was the sovereign debt crisis of 2011-12, which was intensified by the
banksovereign nexus. Bank funding markets fragmented along national lines and banks in vulnerable
countries lost access to wholesale funding. It led to a serious disruption of the monetary
transmission mechanism and prevented our accommodative policy stance from reaching the
economy.
Our policy response was twofold. First, we carried out two three-year refinancing operations at
the end of 2011 and beginning of 2012. Second, we announced our conditional Outright Monetary
Transactions in summer 2012, which acted as a powerful circuit breaker against self-reinforcing
fears in sovereign bond markets. But the sovereign debt crisis nonetheless left the economy with
a damaging legacy and paved the way for the third phase of the crisis.
As the euro area entered into a prolonged slump, banks in many parts of the euro area embarked
on a slow process of deleveraging, mainly by reducing lending. A credit crunch was looming: by
end-2013 loans to the private sector were falling by more than 2% per year. By mid-2014, the
economic recovery was losing momentum and the weakness in aggregate demand was starting
to depress inflation expectations. The sharp fall-off in oil prices that began in late summer
exerted further disinflationary pressures.
Given the weak underlying trend in inflation, we saw a growing risk that low inflation could
deanchor inflation expectations and unleash a deflationary spiral. Short-term interest rates that
were already close to zero hampered our ability to use conventional monetary policy instruments.
The ECB had to resort to a new approach to ease its monetary stance, based more on directly
influencing the whole constellation of interest rates that are relevant for the financing conditions of
the economy. This strategy was articulated in three measures.
The first was the launch of a negative interest rate policy, as we lowered the interest rate paid on
our deposit facility to -0.1% in June 2014. The second instrument was our targeted longer-term
refinancing operations (TLTROs), which are specifically designed to support bank lending to the
private sector. The third instrument was our asset purchase programme (APP) involving private
and public sector securities, which helped further depress the term structure of interest rates by
compressing risk premia out along the yield curve.
These instruments were complemented by the use of forward guidance, where we started to
communicate about our expectations of future policy, along with the conditions that would
warrant a change in the policy stance.
A solid and broad-based economic expansion with subdued price pressures
Our monetary policy strategy has borne fruit. We have now seen 18 quarters of positive growth
and the short-term economic indicators all point to a continued economic upswing with
abovetrend growth. The breadth of the expansion is notable: the dispersion of growth rates across both
countries and sectors is at its lowest level for two decades.
The euro area recovery has so far been mostly home-grown, with monetary policy creating the
conditions for a virtuous circle between rising income and spending in both the corporate and the
household sector. Annual growth in employment has reached its highest level since before the
crisis and the unemployment rate fell to 8.7% in November, the lowest rate for nearly nine years.
An important factor underlying the good performance of domestic demand is the very favourable
financing conditions for firms and households, which are heavily influenced by our policy
measures. Bank lending rates to non-financial corporations (NFCs) have fallen by around 120
basis points since June 2014, a large proportion of which can be attributed to the impact of our
measures.
Moreover, the decline has been more marked in those countries that suffered more acutely from
financial fragmentation during the crisis, showing that our measures have not only provided the
necessary monetary accommodation, but also rehabilitated the transmission mechanism to
ensure an even transmission of monetary policy throughout the euro area. Loans to NFCs -
sharply down when we introduced our unconventional measures - are growing again, and
reached an annual growth rate of 2.9% in December 2017.
Taking these factors together, the overall impact of the ECB's policy measures since mid-2014
are estimated to have contributed significantly to output growth - and by around half a
percentage point in 2017.
While our measures have clearly played a decisive role in keeping inflation expectations
anchored and have contributed to an improved inflation outlook, an ample degree of monetary
accommodation remains necessary to secure a sustained return of inflation rates towards levels
that are below but close to 2%, as reaffirmed by the Governing Council at last week's meeting.
Despite the strong cyclical momentum, domestic price pressures remain subdued, as do
measures of underlying inflation.
The evolution of the ECB's forward guidance
Our monetary policy stance is determined by the combination and mutual interaction of our asset
purchase programme, our policy rates and our forward guidance on each of these tools. The
stimulus provided by these policy tools is complemented by the TLTROs, which will remain
outstanding for the next three years.
When our key policy rates reached exceptionally low levels, asset purchases became the main
monetary policy instrument for calibrating our stance. This is why, since January 2015, when the
APP started, we have been signalling the traditionally tight connection between the ECB's
monetary policy and our price stability objective by linking an assessment of the medium-term
outlook for inflation to the size and duration of our net asset purchases. Accordingly, when
communicating about net purchases, we have expressed our intention to continue with our
chosen pace of monthly purchases until we see "a sustained adjustment in the path of inflation
consistent with our inflation aim". This phrase describes the key contingency that has guided the
course of our policy in the past few years and will continue to do so in the future. In addition, the
pledge to re-invest the proceeds from the principal payments that accrue from the maturing
securities in our portfolio should be seen as a necessary complement to the net asset
purchases.
Central bank asset purchases ease monetary conditions primarily by taking long-duration bonds
out of private hands. It is by withdrawing such assets from the market and holding them for a
possibly lengthy period of time that the central bank spurs a rebalancing of private portfolios, and
thus lowers term premia and eases financing conditions.
Forward guidance on both policy rates and the APP plays a key role in determining our monetary
policy stance. Its function has evolved significantly over time. Before the APP was launched, our
forward guidance related only to the expected path of our policy rates. When the Governing
Council decided to start issuing statements on its expectations concerning the future evolution of
the ECB's key interest rates, in July 2013, forward guidance was mainly intended to insulate the
euro area from external tightening pressures, notably those originating from the global financial
turmoil that had followed the "taper tantrum" a few weeks before.
As macroeconomic conditions deteriorated in the course of the following year, though, the
statement that the Governing Council expected "the key ECB interest rates to remain at present
or lower levels for an extended period of time" turned into a vehicle for easing the monetary policy
stance.
With the adoption of our APP, forward guidance has been extended to key parameters of our
purchases, and has helped investors form expectations about the size of APP and its duration.
We have indicated a minimum horizon - an intentional end-date - until which time we plan to
carry out net monthly purchases, while always retaining the option of extending the programme
beyond that intentional end-date if the "sustained adjustment" condition has not been met. In
October 2017, for example, as we extended our net purchases past the end of the year, we
signalled that, starting in January 2018, we would "continue at a monthly pace of €30 billion until
the end of September 2018, or beyond, if necessary, and in any case until the Governing
Council sees a sustained adjustment in the path of inflation consistent with its inflation aim".
Moreover, in view of the key role played by the accumulated stock of assets in our portfolio as an
ongoing source of stimulus, we committed to "reinvest the principal payments from maturing
securities purchased under the APP for an extended period of time after the end of its net asset
purchases, and in any case for as long as necessary."
Our instruments are configured in such a way that our forward guidance on policy rates has
been reinforced by our forward guidance on net asset purchases. We have linked the expected
path of our key interest rates to the intended horizon of the net asset purchases by saying that
we "expect them to remain at their present levels for an extended period of time, and well past
the horizon of our net asset purchases". This sequenced guidance has served to exploit
important complementarities between policy rates and asset purchases. On the one hand,
having the horizon over which policy rates are expected to remain constant tied to - and longer
than - the APP horizon has largely prevented the easing impact of our purchases on the yield
curve from being countered by a destabilisation of short-term interest rate expectations. On the
other hand, announcing that the APP would have a certain lifespan signalled that policy rates
would remain at their present levels for longer. And this has reinforced the power of the
statements concerning the evolution of the policy rate path. The forward guidance on policy rates
acts as an enabling condition for the purchases to exert their full impact on term premia, and the
language on the intended horizon of our net asset purchases has reinforced the signalling power
of our forward guidance on rates.
Looking ahead, the question is: how will our monetary policy toolbox evolve in the foreseeable
future? Monetary policy will evolve in a data-dependent and time-consistent manner. The
transition towards a normalisation will begin once we have established that there is a sustained
adjustment in the path of inflation. Our assessment will be based on three criteria for the inflation
outlook: convergence, confidence and resilience.
First, convergence: headline inflation will have to be on course to reach levels below, but close
to, 2% by the end point of a meaningful medium-term horizon. Two things are noteworthy here:
the salience of our inflation aim and the forward-looking perspective. There should be no doubt
about our steadfast commitment to secure a sustained return of inflation rates towards levels
that are below, but close to,, 2%. And the perspective should be forward-looking because our
monetary policy framework directs us to shape monetary policy with a firm medium-term
orientation. Since the start of Monetary Union, the ECB's monetary policy has always been
formed with a view to stabilising medium-term headline inflation around levels that are most
consistent with our price stability definition. Since 2003, we have said that those levels should be
below, but sufficiently close to, 2%.
The second criterion on which our assessment is based is confidence, since meeting the first
criterion - convergence - is a necessary but not sufficient condition for a sustained adjustment.
The Governing Council wants to be sure that the expectation of an upward adjustment in inflation
has a sufficiently high probability of being realised and is being met on a sustainable basis, i.e.
not as the result of a transitory shock or measurement error. In other words, we need to build
strong confidence in the accuracy of our baseline outlook for inflation: the range of possible
outcomes around that baseline path should be reasonably contained. This is our second criterion
for a sustained adjustment. At our last Governing Council meeting, we have communicated our
increasing confidence that inflation will converge towards our inflation aim of below, but close, to
2%.
How can we substantiate today that inflation convergence has sufficiently strong legs to support
its upward trajectory towards our aim? By looking at a broad range of indicators of price
pressures, for example measures of inflation trends, notably including core inflation indices. As
these underlying inflation statistics - available today - contain information that is valuable for
predicting the level of headline inflation in the future, when short-term shocks that may influence
its level today have faded away, we want to cross-check our medium-term projections for
headline inflation with these measures. In parallel, an eye on capacity utilisation and the extent of
unutilised resources can help reinforce our confidence in inflation convergence as a more robust
real economy is likely to support a build-up of broad-based price pressures looking forward.
Our third criterion, resilience, measures the robustness of inflation convergence to a partial
withdrawal of monetary policy accommodation. If the inflation outlook is overly dependent on
monetary support, the upward adjustment cannot be considered sustained. So, we want to verify
that the path would be maintained even in less supportive monetary policy conditions.
Today, we are still some distance away from meeting all three criteria at the same time. So, we
still need patience and persistence in steering our policy conduct.
Patience is necessary because it takes time for price pressures to build up, and to be reflected in
the information that forms the basis for our assessment of progress towards a sustained
adjustment in the path of inflation.
Persistence is necessary because the recovery in inflation is, in itself, a consequence of the
prevailing accommodative monetary policy stance. Even if incoming data were to validate the
expectation of a gradual build-up of inflationary pressures, this would not be sufficient to affirm a
sustained adjustment, if even less supportive monetary policy conditions were to imperil the
inflation trajectory.
Monetary policy will evolve in a data-dependent and time-consistent manner. Once the Governing
Council judges that the three criteria for sustained adjustment have been met, net asset
purchases will expire, in line with our guidance. From that point in time, the evolution of inflation
will remain conditional on reinvestments continuing for an extended period of time and on policy
rates remaining at their present levels well past the end of our net asset purchases. The stock of
long-duration assets held in our portfolio will continue to put downward pressure on longer-term
interest rates well beyond the end of our net purchases. Policy rates remaining at their present
levels well past the end of our net purchases will contribute to holding the short to intermediate
portions of the yield curve in check for as long as necessary, thereby ensuring that financial
conditions remain consistent with a sustained adjustment of inflation.