Mario Draghi: Twenty years of the European Central Bank's
monetary policy
Speech by Mr Mario Draghi, President of the European Central Bank, at the ECB Forum on
Central Banking, Sintra, 18 June 2019.
* * *
Central banks were often established in the past with the aim of bringing stability in the aftermath
of historic episodes. The Bank of England was established during the sovereign debt crisis of
1690, when the government was unable to obtain funding in the market. The Federal Reserve
was created after a series of panics that had rocked the US banking system in the late 19th and
early 20th century.
The euro was introduced 20 years ago in response to repeated episodes of exchange-rate
instability and the need to secure the Single Market against competitive devaluations. The ECB
was established as the keystone of the new Economic and Monetary Union (EMU).
The first decade of the Monetary Union was characterised by calm macroeconomic conditions,
with limited volatility and steady economic growth. The second decade, however, has seen
profound shifts in the prevailing environment - including both financial and sovereign debt crises
- and our monetary policy strategy has had to adapt with it.
I would like to discuss this morning why this evolution came about and how it was achieved -
and what the past twenty years can tell us about the ECB's monetary policy in the future.
Monetary policy before the crisis
The ECB's mandate is given by the Treaty as price stability. In 1998, the Governing Council
defined price stability as inflation within a range of 0-2% over the medium term, which constitutes
the ECB's objective. Then, in 2003, the Governing Council clarified that, within this range, it would
aim at a focal point of below, but close to, 2%, which remains our medium-term aim to this day.
This was a formulation that differed from the standard inflation-targeting framework of the time,
which was typically based around a point target for inflation. But there were sound reasons why
this definition was put in place.
In common with central banks across the world, the ECB faced a macroeconomic environment
before the crisis that was predominantly defined by low volatility and moderate shocks, with the
distribution of shocks to inflation almost exclusively to the upside. In the euro area, HICP energy
prices rose by 80% between January 1999 and September 2008. Under these conditions,
establishing a strong reaction function against high inflation was seen as crucial to anchor
inflation expectations. Emphasising an aim of "below, but close to, 2%" was seen to imply a
stronger commitment than a standard inflation-targeting regime.
But monetary policy in the euro area also faced a special challenge. The ECB was a new central
bank operating in a very heterogeneous monetary union, which created a particular imperative to
establish inflation credibility. Establishing a commitment to controlling inflation was seen as
critical to cement lower inflation expectations across the euro area - especially as moderate
inflation was a relatively new phenomenon in several Member States.
Over the two decades up to 1999, inflation had averaged above 3% in 10 of the 12 original
members. The decline in inflation in many countries in the run-up to EMU was in large part due to
expectations of joining, as well as to a number of extraordinary actions taken by national
authorities to meet the convergence criteria. From 1989-99, long-term inflation expectations had
fallen from a range of between 2.5-4.5% in the four largest euro area economies to below 2%
across the board. It was now the task of the new central bank to lock in this moderate-inflation
environment - and it did so successfully. Over the next decade, inflation expectations
internalised the ECB's commitment to keep inflation down and remained below 2%.
But this process of building inflation credibility had implications for the ECB's reaction
function. As a matter of accounting, stabilising headline inflation largely caused by its volatile
components must mean that core inflation adjusts downwards. Rolling cross-correlations
between energy inflation and core inflation show that an episode of high energy inflation between
1
1999 and 2007 was accompanied by a period of rapidly softening core inflation. As a result,
between January 1999 and September 2008 headline inflation in the euro area averaged 2.35%,
while core inflation averaged 1.7% and exceeded 2% less than 15% of the time.
Central banks in other advanced economies faced similar challenges and adopted similar
strategies. But differences in mandates - and length of track records in fighting inflation - led to
differences in how much energy price pass-through to headline inflation others were comfortable
accommodating. For example, energy prices in the US CPI rose by 160% over the same
2
period and headline inflation averaged 2.9%. The Federal Reserve reacted less to headline
3
inflation, and core CPI inflation averaged 2.2%.
The upshot was that the euro area entered the crisis having succeeded in establishing its
antiinflation credentials, but with underlying inflation dynamics that were perhaps relatively weaker.
This was not immediately apparent, as inflation stayed at fairly elevated levels for more than four
years after the Lehman crash. Monetary policy responded decisively to the global financial crisis
and disinflationary threats seemed to pass quickly.
But in hindsight it seems reasonable to conclude that the inflation process was vulnerable to
a shift in the environment - which is what transpired from around mid-2012 onwards.
New challenges for monetary policy
At this point, headline inflation in the euro area began what was, in retrospect, a prolonged
downward drift, and core inflation fell by almost a percentage point from mid-2012 to early 2014.
There are two factors that help explain the switch to a disinflationary trend.
First, the distribution of shocks to inflation moved strongly to the downside and the
amplitude of the shocks increased. Supply-side shocks gradually dissipated over the years
following the Lehman crash and the sovereign debt crisis. Negative demand shocks, driven at
different times by domestic demand and external demand, instead became the dominant source
of macroeconomic fluctuations in the euro area. ECB analysis shows that negative demand
shocks have weighed on euro-area inflation by more than 1 percentage point on average since
the start of the crisis. In the previous ten years, their effect was neutral overall, with periods of
4
both upward and downward pressure.
The second factor was a change in the macroeconomic policy mix. While in the first phase of
the crisis fiscal and monetary policy had eased in tandem - with fiscal policy loosening by a total
5
of about 3% of potential GDP between 2008 and 2010 - thereafter the stance of monetary and
fiscal policy decoupled. The euro area fiscal stance turned contractionary in response to the
sovereign debt crisis, tightening by around 4 percentage points of potential GDP until 2013 -
years the euro area was mostly in recession.
This stands in contrast to the United States, where fiscal policy eased more in the initial phase of
the crisis, by about 6.5% of potential GDP in total over 2008-09, and then tightened by about
5.5% of potential GDP from 2011 to 2013 when the economic recovery was underway. The euro
area was forced onto a different path by the need in some countries to re-establish fiscal
credibility. But on aggregate the euro area did not have less fiscal space than the United States:
public debt levels were similar in the two jurisdictions. The key difference was that fiscal
stabilisation in the United States took place at the federal level, while the euro area lacked a
central fiscal instrument to act counter-cyclically.
The policy mix is also relevant when it comes to financial sector policies. After the crisis, it
was inevitable that banking sectors in advanced economies would have to deleverage, both to
cover losses and to re-focus their business models. The United States ensured that this process
happened quickly and early. Around 500 failing banks were resolved by the Federal Deposit
Insurance Corporation, while struggling banks were stress-tested and recapitalised through the
Troubled Assets Relief Program. Between 2008 and 2011, US banks improved their leverage
6
ratio by 1.6 percentage points from 7.2 to 8.8%.
The response in the euro area was more sluggish. Despite being more levered than their US
peers before the crisis, euro area banks improved their leverage ratio by just 0.9 percentage
points, from 3.7 to 4.6%, and this was achieved more through shedding assets and less through
7
raising capital. This in part reflected the fact that, due to the fiscal rules, public support for banks
was concentrated in countries with fiscal space. Moreover, without a common resolution
8
framework only around 50 banks were resolved in the euro area in this period. So a weak
banking sector continued to drag on the euro area economy, which was especially pernicious
given the importance of the banking lending channel for financing.
In sum, the ECB faced an environment where there was both an increasing need to counter
demand shocks, and an increasing burden on monetary policy to do so.
Our strategy therefore
had to adapt to these new circumstances in order to continue delivering our aim.
Monetary policy responded first in the summer of 2012 by acting to defuse the sovereign debt
crisis, which had evolved from a tail risk for inflation into a material threat to price stability.
Announcing Outright Monetary Transactions (OMT) established our commitment to counter
unwarranted redenomination risks in sovereign debt markets and acted as a powerful circuit
breaker.
While OMT was never activated, the effect of its announcement was equivalent to that of a
largescale asset purchase programme: spreads in vulnerable countries fell on average by more than
400 basis points over the next two years. The macroeconomic impact of OMT was also
analogous to other purchase programmes: ECB research finds that the GDP and price effects of
OMT were broadly in line with those estimated for the QE that took place in the United States and
9
the United Kingdom.
But the lingering effects of the sovereign debt crisis dented the capacity of this stimulus to
counter the new disinflationary trend. The delayed bank deleveraging process in the euro area
began to accelerate, with banks further shrinking their balance sheets and paying back central
bank loans. Bank balance sheets declined by around 20 percentage points of GDP in 2013 alone
and, at the end of 2013, credit growth to the private sector was contracting at a rate of 2.4%
relative to a year earlier. On the demand side, risk appetite in the private sector collapsed, with
investment subtracting 1.6 percentage points from GDP growth in 2012.
The ECB therefore reacted again in 2013 by cutting its main refinancing rate twice, from 0.75%
to 0.25%, and by seizing the opportunity of the launch of European banking supervision. We
carried out a comprehensive assessment of bank balance sheets, with the aim of steering the
process of balance sheet repair towards a positive macroeconomic outcome. Banks
10
strengthened their balance sheets by over €200 billion in advance of the outcome. That put the
banking sector in a much stronger position to transmit our policy.
But at this point, the euro area economy was hit by a further downward shock to inflation in the
form of a 60% collapse in oil prices in mid-2014, which pushed inflation into negative territory.
With underlying inflation already weakening, inflation expectations began to be affected. As the
scope for further interest rate cuts was now limited, it became increasingly clear that our
reaction function needed to evolve to address these new challenges.
Indeed, since our policy framework had never been systematically tested by persistent
disinflationary risks, the ECB had not yet had a chance to demonstrate its intolerance for inflation
remaining below its aim for protracted periods of time.
At the same time, there appeared to be some uncertainty about which tools we would be able to
deploy if the effective lower bound were reached. Unlike in other major economies, the ECB had
not resorted to large-scale asset purchases during the global financial crisis and its aftermath.
Some even questioned the legality of asset purchases in Europe and their effectiveness in our
bank-based economy.
If these uncertainties were not removed, there was a material risk that falling inflation could
become self-fulfilling: the public could begin expecting a smaller monetary policy response to
future inflation undershoots, and revise their inflation expectations further downwards.
In other words, credibility now relied not just on perceptions of the ECB's commitment to our aim,
but also on perceptions of our capability to fight low inflation. We responded to the situation in
three main ways.
The ECB's policy response
The first was by clarifying the symmetry of our aim. While the quantitative definition of price
stability was instrumental in establishing credibility in the first decade, its asymmetric formulation
may have led to misperceptions in a low-inflation environment. Thus we made clear that our
11
policy aim was fully symmetric, and it was symmetric around the level that we had established
in 2003: below, but close to, 2%. It is achieving this aim over the medium term that steers our
policy decisions.
In addition, we clarified that symmetry meant not only that we would not accept persistently low
inflation, but also that there was no cap on inflation at 2%. As I emphasised on a number of
12
occasions, our medium-term orientation implies that inflation can deviate from our aim in both
directions, so long as the path of inflation converges back towards that focal point over the
medium-term policy horizon.
The second part of our response was to lay out the tools we would use to counteract
downside inflation risks, which began with a speech I gave in Amsterdam in April 2014 that
described three contingencies and the instruments we would use to react to them. This
established unambiguously that we had no taboos about resorting to unconventional
13
measures. There was nothing institutionally or legally special about the euro area that
prohibited monetary policy from adding accommodation once the lower bound was approached.
Third, as these various contingencies played out, we operationalised our reaction function by
launching a series of new instruments. We broke through the zero bound by lowering our
deposit rate into negative territory, launched our targeted longer-term refinancing operations
(TLTROs) to provide incentives for banks to lend, and implemented a large-scale asset
purchase programme (APP) of public and private securities. These measures were deliberately
designed to work as a package and ease the stance through complementary channels, working
both through banks and the wider matrix of capital markets.
The negative rate policy challenged market expectations that when rates reached zero they could
only go up and not down, which helped skew the distribution of rate expectations and depress the
short end of the risk-free curve - a key benchmark for the pricing of bank loans. Asset purchases
in tandem compressed yields at the longer end of the curve, pushing down mortgage rates and,
at the same time, making bank lending to firms more attractive in risk-adjusted terms. And
bankbased transmission was amplified by the TLTROs, which lowered funding costs and increased
competition among banks.
14
Over time, we also enhanced this framework with state- and date-based forward guidance ,
allowing us to rotate the marginal tool for determining the policy stance from asset purchases to
forward guidance as the economic outlook improved. Today, this forward guidance links our
expectations on the path of future rates to the path of inflation towards our aim, leading to
automatic easing if the convergence path towards 2% is delayed.
15
There is mounting evidence that these instruments have been effective. Negative rates have
proven to be a very important tool in the euro area - and more so than they would have been in
an economy like the United States. Indeed, the Federal Reserve eschewed negative rates in part
due to concerns about their effects on the money market industry, which are key intermediaries
in the US financial system. But this factor is less relevant in the euro area, since many money
market funds have been operating as Variable Net Asset Value funds, and therefore are more
flexible to extend duration to seek additional returns.
Furthermore, the euro area is a relatively open economy for its size, with total trade making up
16
51% of GDP, compared with 27% in the United States. This means that the impact of negative
rates on inflation and financing conditions via the exchange rate is more powerful.
In short, faced with a new environment of downside risks and limited conventional policy space,
the ECB showed that it had no shortage of tools available to respond. Unconventional measures
proved suitable substitutes for conventional ones: using market prices to construct a so-called
17
"shadow short rate", the stimulus provided appears broadly in line with the recommendation of
18
monetary policy rules as suggested by recent academic research.
Our capacity to react in this way was made possible by the flexibility embedded in our mandate -
a flexibility that was confirmed by the recent ruling of the European Court of Justice. This not only
affirmed that asset purchases are a legal instrument of monetary policy in the euro area, but
emphasised the broad discretion of the ECB in using all our tools in a necessary and
proportionate way to achieve our objective.
However, although we have seen the successful transmission of monetary policy to financing
conditions, and from financing conditions to GDP and employment, the final legs of the
transmission process to wages and inflation have been slower than we expected. Wage growth
is now strengthening as slack in the labour market diminishes. But the pass-through from wages
to prices remains weak. This may reflect structural changes, such as globalisation and
digitalisation, which mostly have an impact at this point in the pricing chain. Lingering cyclical
weakness can also delay wage-price pass-through as firms elect to squeeze margins rather
19
than raise prices and risk losing market share.
Current challenges for monetary policy
In this environment, what matters is that monetary policy
remains committed to its objective
and does not resign itself to too-low inflation. And, as I emphasised at our last monetary
policy meeting, we are committed, and are not resigned to having a low rate of inflation forever or
even for now.
We have described the overall orientation of our monetary policy as being
"patient, persistent
and prudent". Patient, because faced with repeated negative shocks we have had to extend the
policy horizon. Persistent, because monetary policy will remain sufficiently accommodative to
ensure the sustained convergence of inflation to our aim. And prudent, because we will pay close
attention to underlying inflation dynamics and to risks and will adjust policy appropriately.
This orientation is expressed in our current policy framework, which allows us to adapt our
forward guidance and react flexibly as the macroeconomic situation evolves. That was illustrated
by the monetary policy decisions taken at our meeting earlier in June.
Looking forward, the risk outlook remains tilted to the downside, and indicators for the coming
quarters point to lingering softness. The risks that have been prominent throughout the past year,
in particular geopolitical factors, the rising threat of protectionism and vulnerabilities in emerging
markets have not dissipated. The prolongation of risks has weighed on exports and in particular
on manufacturing.
In the absence of improvement, such that the sustained return of inflation to our aim is
threatened, additional stimulus will be required.
In our recent deliberations, the members of the Governing Council expressed their conviction in
pursuing our aim of inflation close to 2% in a symmetric fashion. Just as our policy framework
has evolved in the past to counter new challenges, so it can again. In the coming weeks, the
Governing Council will deliberate how our instruments can be adapted commensurate to the
severity of the risk to price stability.
We remain able to enhance our forward guidance by adjusting its bias and its conditionality to
account for variations in the adjustment path of inflation.
This applies to all instruments of our monetary policy stance.
Further cuts in policy interest rates and mitigating measures to contain any side effects remain
part of our tools.
And the APP still has considerable headroom. Moreover, the Treaty requires that our actions are
both necessary and proportionate to fulfil our mandate and achieve our objective, which implies
that the limits we establish on our tools are specific to the contingencies we face. If the crisis has
shown anything, it is that we will use all the flexibility within our mandate to fulfil our mandate -
and we will do so again to answer any challenges to price stability in the future.
All these options were raised and discussed at our last meeting.
What matters for our policy calibration is our medium-term policy aim: an inflation rate below, but
close to, 2%. That aim is symmetric, which means that, if we are to deliver that value of inflation
in the medium term, inflation has to be above that level at some time in the future.
But fiscal policy should play its role. Over the last 10 years, the burden of macroeconomic
adjustment has fallen disproportionately on monetary policy. We have even seen instances
where fiscal policy has been pro-cyclical and countered the monetary stimulus.
If the unbalanced macroeconomic policy-mix in the euro area in part explains the slide into
disinflation, so a better policy mix can help bring it to a close. Monetary policy can always achieve
its objective alone, but especially in Europe where public sectors are large, it can do so faster
and with fewer side effects if fiscal policies are aligned with it.
Recreating fiscal space by raising potential output through reforms and public investment, and
respecting the European fiscal framework will maintain investor confidence in countries with high
public debt, low growth and low fiscal space. But as fiscal expansion in the other countries may
have limited spillovers, national fiscal policies remain constrained. So work on a common fiscal
stabilisation instrument of adequate size and design should proceed with broader scope and
renewed determination.
Conclusion
Let me conclude.
The euro was introduced twenty years ago in order to insulate the Single Market from
exchangerate crises and competitive devaluations that would threaten the sustainability of open markets. It
was also a political project that, relying on the success of the Single Market, would lead to the
greater integration of its Member States.
On both counts, the vision of our forefathers has scored relatively well. Imagine where the Single
Market would be today, after the global financial crisis and rising protectionism, had all countries
in Europe been free to adjust their exchange rates. Instead, our economies integrated, converged
and coped with the most severe challenge since the Great Depression. That leads me to four
observations.
First, the integration of our economies and with it the convergence of our Member States has
also greatly increased. Misalignments of real effective exchange rates between euro area
countries are about a half those between advanced economies with flexible exchange-rates or
countries linked by pegged exchange rates and they have fallen by around 20% in the second
20
decade of EMU relative to the first.
Second, the dispersion of growth rates across euro area countries, having fallen considerably
since 1999, is since 2014 comparable to the dispersion across US states. Third, this has been
driven in large part by the deepening of European value chains, with EMU countries now
significantly more integrated with each other than the United States or China are with the rest of
21
the world. Most EMU countries export more with each other than with the US, China or Russia.
Fourth, employment in the euro area has reached record highs and in all euro area countries but
one stands above its 1999 level.
But the remaining institutional weaknesses of our monetary union cannot be ignored at the cost
of seriously damaging what has been achieved. Logic would suggest that the more integrated
our economies become, the faster should be the completion of banking union and capital
markets union, and the faster the transition from a rules-based system for fiscal policies to an
institution-based fiscal capacity.
The journey towards greater integration that our citizens and firms started twenty years ago has
been long, far from finished, and with broad but uneven success. But overall, it has strengthened
the conviction of our peoples that it is only through more Europe that the implications of this
integration can be managed. For some, that trust may lie in a genuine faith in our common
destiny, for others it comes from the appreciation of the greater prosperity so far achieved, for yet
others that trust may be forced by the increased and unavoidable closeness of our countries. Be
that as it may, that trust it is now the bedrock upon which our leaders can and will build the next
steps of our EMU.
1
Rostagno et al. (2019), forthcoming.
2
The difference in growth in energy prices between the euro area and the United States can in large part be
attributed to differences in tax rates, which are typically higher in the euro area. As such, the share of the final
price paid by consumers accounted for by oil is much smaller in the euro area, and CPI energy prices are less
affected in aggregate by movements in oil prices. That being said, the energy component has a higher weight in
euro area HICP, so a 1 percentage point increase in CPI energy prices has a greater impact on headline
inflation in the euro area than in the United States.
3
The equivalent figure for core PCE inflation was 1.9%.
4
Rostagno et al. (2019), op.cit.
5
Measured as the change in the cyclically adjusted primary balance.
Leverage ratio calculated as Tier 1 capital/Total assets. Source: Consolidated Banking Data for euro area banks
and FDIC data for US banks.
7
It should be noted that deleveraging was also more challenging in Europe than in the US, given the larger size
of bank balance sheets relative to GDP and less developed market-based finance.
8
Sapir, A. and Wolff, G. (2013), "The neglected side of banking union: reshaping Europe's financial system",
note presented at the informal ECOFIN on 14 September 2013, Vilnius.
9
Altavilla, C., Giannone, D. and Lenza, M. (2016), "The Financial and Macroeconomic Effects of the OMT
Announcements", International Journal of Central Banking, 12(3): 29-57.
10
See ECB's in-depth review shows banks need to take further action, Press release, 26 October 2014.
11
For example, in the February 2014 press conference, the ECB President responded to a question about the
symmetry of the inflation objective on the downside by recalling that the central bank did not "have a cool attitude
at all with respect to the present level of inflation rates [...] these levels of inflation for a protracted period of time,
are a risk on their own [...] so, we [still] have a symmetric attitude."
12
For example, at the press conference in March 2016, the ECB President noted that "our mandate is defined as
reaching an inflation rate which is close to 2% but below 2% in the medium term, which means that we'll have to
define the medium term in a way that, if the inflation rate was for a long time below 2%, it will be above 2% for
some time. The key point is that the Governing Council is symmetric in the definition of the objective of price
stability over the medium term."
13
Draghi, M. (2014), "Monetary policy communication in turbulent times", Speech at the Conference De
Nederlandsche Bank 200 years: Central banking in the next two decades, Amsterdam, 24 April.
14
Forward guidance on interest rates had first been introduced in 2013 but was enhanced in this period.
15
For a review of the evidence see Hammermann, F., Leonard, K., Nardelli, S. von Landesberger, J. (2019),
"Taking stock of the Eurosystem's asset purchase programme after the end of net asset purchases", ECB
Economic Bulletin, Issue 2 / 2019.
16
Measured as total extra-euro area trade in goods and services as a share of GDP.
17
See Krippner, L. (2015), Term Structure Modeling at the Zero Lower Bound: A Practitioner's Guide,
PalgraveMacmillan.
18
Bobeica, E., Ciccarelli, M. and Vansteenkiste, I. (2019), "The link between labor cost and price inflation in the
euro area," Working Paper Series, No. 2235, European Central Bank.
19
Fidora, M., Giordano, C. and Schmitz, M. (2017), "Real exchange rate misalignments in the euro area", Working
Paper Series, No. 2108, ECB.
20
Imbs, J. and L. Pauwels (2019), "Twenty Years of Convergence", paper presented at ECB Forum on Central
Banking, 17-19 June 2019.
21
Hartmann, P. and Smets, F. (2018), "The first twenty years of the European Central Bank: monetary policy,"
Working Paper Series, No. 2219, European Central Bank, forthcoming in the Brookings Papers on Economic
Activity.