Philip R Lane: External and internal spillovers
Speech by Mr Philip R Lane, Governor of the Central Bank of Ireland, at the 56th ACI FMA World
Congress, Dublin, 12 May 2017.
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Introduction
1
It is an honour to speak at the ACI World Congress and welcome delegates to Dublin.
Today, I wish to discuss two types of macro-financial interactions that are relevant in
understanding the macro-financial dynamics of the euro area. First, there are inward and
outward linkages between the euro area and the rest of the world that may generate external
spillovers by which shocks and policies elsewhere affect macro-financial conditions in the euro
area and, in turn, shocks and policies in the euro area matter for macro-financial conditions in the
rest of the world. Second, there are even stronger linkages across the member countries within
the euro area, such that internal spillovers matter for each member state in the euro area.
Both external and internal spillovers are relevant in evaluating the impact of the ECB's monetary
policy. In particular, the ECB has pursued a multi-dimensional monetary policy since mid-2014
that has combined a negative deposit rate, an asset purchase programme, targeted long-term
refinancing operations (TLTROs) and forward guidance on the expected future path for its
policies. This strategy was adopted in recognition of the risk of persistent under-shooting of its
inflation target, including a tail risk of deflation.
As captured in the introductory statement to the most recent monetary policy press conference
on 27th April 2017, the Governing Council of the ECB expects the key ECB interest rates to
remain at present or lower levels for an extended period of time and well past the horizon of its
net asset purchases. Net asset purchases are expected to run at a monthly pace of €60 billion
until the end of December 2017 or beyond, if necessary, and in any case until the Governing
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Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.
The assessment of the Governing Council is that this very substantial degree of monetary
accommodation is still needed for underlying inflation pressures to build up and support headline
inflation in the medium term. If the outlook becomes less favourable, or if financial conditions
become inconsistent with further progress towards a sustained adjustment in the path of
inflation, the Governing Council stands ready to increase the asset purchase programme in
terms of size and/or duration.
In analysing the stance of monetary policy, it is essential to incorporate the impact of external
conditions on the design of the ECB's monetary measures, while also recognising the role of the
external sector in determining their effectiveness. From a global perspective, the external
spillovers from the ECB's monetary strategy also matter for macro-financial conditions
elsewhere and may affect optimal monetary strategies for other central banks.
In addition, from the perspective of individual member countries, the national impact of the ECB's
monetary strategy depends on a host of country-specific factors, together with the indirect
impact through the matrix of inter-linkages among the member countries. To the extent that there
is a mis-match between the current macro-financial conditions in an individual member country
and the ECB's monetary stance, this can be analytically viewed as a type of internal spillover
generated by the deviation vis-a-vis macro-financial conditions in the rest of the euro area. We
will return to the analysis of internal spillovers later in the speech.
External spillovers
In thinking about external spillovers, it is important to bear in mind that nature and magnitude of
spillovers varies over time, across regions and across different states of the world. Accordingly,
it is essential to adopt an empirical approach in assessing the role of spillovers at a given point in
time.
To this end, let me make a few empirical observations.
First, as shown in Figure 1, the share of world GDP (measured in current US dollars) that is
generated by emerging and developing countries has risen sharply from about 20 percent in
2000 to 30 percent in 2007 and 40 percent in 2017. In relation to the trade channel, Figure 2
shows that this group is collectively far more important than the United States as a trading
partner for the euro area. It follows that the assessment of macro-financial conditions in these
economies is an important task in determining the appropriate monetary stance for the euro
area.
Second, the nature of external linkages and spillovers inevitably varies with the current state of
the euro area economy. To take just one dimension, some transmission mechanisms are a
function of output levels, while others are a function of domestic expenditure levels. Accordingly,
the cross-border transmission of shocks and policies will differ depending on the direction and
magnitude of the euro area's trade balance, which is simply the difference between output and
expenditure.
Figure 3 shows net exports as a share of GDP for the euro area: the current net surplus position
means that the domestic expenditure level in the euro area is running substantially below the
output level. A related point is captured in Figure 4 that shows the time-varying accounting
contribution of net exports to GDP in the euro area. While net exports were quite significant
during 2010-2013 and again during 2015 (the first full year of the ECB's accommodative
monetary strategy), the accounting contribution of net exports was marginally negative during
2016.
Third, the extent and composition of international financial linkages matter for external spillovers
that operate through financial channels. Drawing on my joint research with Gian Maria
MilesiFerretti of the International Monetary Fund, Figure 5 shows the expansion in the size of
international balance sheets (relative to world GDP) since 1990. Furthermore, it illustrates the
increase in prominence of financial centres as intermediaries of international financial assets and
liabilities and the rising prominence of emerging and developing countries as holders and issuers
of international financial positions.
In relation to the former, the intermediation of financial flows through international financial
centres calls for a deeper level of analysis in order to understand the underlying sources and
destinations for international financial flows, which is hampered by the considerable data gaps in
the tracking of international financial transactions. In relation to the latter, increasing
interdependence means that close monitoring of financial conditions in emerging economies is
essential in evaluating risks to domestic financial conditions in advanced economies.
Fourth, the external value of the euro has varied sharply across time. This matters for the
transmission of shocks and policies both through output and financial channels. As an
illustration, Figure 6 shows the euro-dollar rate over 1999-2017. Even if 1999-2001 depreciation
and 2002-2007 appreciation of the euro against the dollar had limited direct impact on the
conduct of monetary policy during the 1999-2007 period, these medium-term fluctuations
plausibly exerted considerable influence on financial conditions in the euro area, given the
extensive bilateral linkages between the US and European financial systems and the unique role
of the dollar in the international financial system.3
More recently, it is plausible that diverging monetary strategies between the ECB and the Federal
Reserve played a role in the appreciation of the euro against the dollar from mid-2012 to
mid2014 and the subsequent depreciation in the second half of 2014 and early 2015. However, in
evaluating the transmission mechanisms of the ECB's accommodative monetary policy, it is
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important to bear in mind the relative stability of the dollar-euro rate since Spring 2015.
Taking into account these empirical patterns, how should we think about the interactions
between external spillovers and the ECB's monetary policy?
In the inward direction, the euro area is affected by macro-financial conditions in the rest of the
world through trade, exchange rate and financial channels.
The relative prices of tradable goods (especially commodities and other non-differentiated goods)
are determined by global supply and demand conditions. Most obviously, the analysis of the
global factors driving the persistent and large-scale fluctuations in oil prices has been a priority
for all central banks in recent years. In addition, global excess capacity may have constrained
pricing for various manufacturing sectors in recent years.
In addition to their influence on the terms of trade, external demand conditions also may boost
domestic output levels, especially in situations in which domestic expenditure levels are weak.
For the euro area, an expansion in net exports clearly played an important role in sustaining
output during 2010-2013 and again in 2015.
Furthermore, it is plausible that the depreciation in the external value of the euro between
mid2011 and mid-2012 and again between mid-2014 and mid-2015 contributed to the expansion in
net exports, while the appreciation phases from mid-2010 to mid-2011 and mid-2012 to mid-2014
represented headwinds to recovery in the euro area.
With the exception of currency reversal during the euro crisis phase of mid-2011 to mid-2012,
the euro persistently appreciated against the dollar from mid-2010 to mid-2014. During this
period, the Federal Reserve implemented several phases of quantitative easing. In turn, the
sharp depreciation of the euro against the dollar from mid-2014 to mid-2015 correlates with the
adoption by the ECB of an accommodative monetary strategy, including asset purchase
programmes, a negative deposit rate, forward guidance and targeted long-term refinancing
operations. At this broad level, it seems clear that differences in the phasing and scope of
monetary strategies account for some proportion of the medium-term swings in the exchange
rate over this period.
While Figure 2 showed that bilateral trade vis-à-vis the US is relatively limited, the importance of
the euro-dollar rate for exporters and importers in the euro area is amplified by the dollar tracking
strategies of many emerging economies, together with the dominant role of the dollar in
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international price setting.
At the same time, the rising share of emerging and developing economies in world GDP (as
captured in Figure 1) means that it is also necessary to allow for the possibility of discrete shifts
in the currency values of major emerging economies (vis-à-vis the euro) that would materially
affect the external environment facing the euro area. For emerging economies, sizeable currency
movements over a short interval may occur through a combination of the greater inherent
volatility of emerging economies and the potential sensitivity of the exchange rate to revisions in
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reserve management strategies. As it has turned out, this risk has not been realised in recent
years, even if concerns have been elevated at various times (including in early 2016).
It is important not to exaggerate the exchange rate as a transmission mechanism for monetary
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policy. In particular, in relation to the ECB's current monetary strategy, the dollar-euro rate and,
more generally, the effective exchange rate for the euro area have been relatively stable since
April 2015 (at least compared to the amplitude of the fluctuations during 2008-2014) and the net
export channel in fact turned negative in 2016.
That is, the ECB's monetary policy has substantially operated through domestic channels over
the last two years, with the improvement in financial conditions facilitating a recovery in domestic
expenditure, led by consumption. It follows that the recovery in the euro area economy in
combination with a stable exchange rate constitutes a positive external spillover for the rest of the
world.
So far, I have focused on external macroeconomic spillovers. In addition, external spillovers may
operate through financial channels. As was illustrated in Figure 5, the scale of cross-border
financial integration has sharply increased over the last two decades, with financial systems
intertwined through two-way cross holdings. Financial conditions in the euro area are affected by
external financial shocks via international balance sheet effects, shifts in international financial
9
flows and common influences on discount factors and risk premia.
The history of the last fifteen years illustrates the importance of global factors in determining
financial conditions. During 2003-2007, easy credit conditions and a risk-on attitude pervaded the
financial systems of advanced economies, which was reinforced by the international reallocation
of liquidity across regions. In turn, this period was followed by the sudden stop of the global
financial crisis during 2008-2009.
Since 2010, there has been more diversity in financial conditions across the globe due to
differences in speed of recovery from the crisis, the state of balance sheets and variation in
policy decisions. Under these conditions, there is greater potential for adverse external policy
spillovers since countries are at different points in the tightening-loosening policy spectrum.
In addition, lower bound constraints mean that it is more problematic for a central bank to offset
an externally-driven tightening in financial conditions through domestic monetary
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easing. Furthermore, a tightening in financial conditions is especially damaging during phases
in which domestic sectoral balance sheets are under repair. Given these constraints, a
welldesigned monetary strategy can provide a strong anchor for domestic financial conditions by
providing clear forward guidance on the commitment of the central bank to meeting its
mediumterm inflation target.
Internal spillovers
Its unique status as a monetary union of nineteen member countries means that it is essential to
address also internal spillovers within the euro area. The high levels of trade and financial
integration among the member countries mean that the scope for cross-border internal spillovers
is especially acute. Indeed, avoiding the disruptive impact of shifts in national currency values
(including from a political economy perspective) was one of the motivating factors behind the
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formation of the monetary union.
Let me focus on a particular type of internal spillover: if macro-financial conditions in an individual
member country substantially deviate from the rest of the euro area, the area-wide monetary
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policy may not be optimal from the perspective of the country in question. In this sense, the
macro-financial conditions in the rest of the euro area spillover to this country through their
impact on monetary policy.
To mitigate the impact of this type of internal spillover, it is now widely accepted that national
macroprudential policies can play an important role, especially in relation to differences in
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financial cycles across member countries. In addition, taking due account of fiscal
sustainability considerations, counter-cyclical national fiscal policies can contribute to
macrofinancial stabilisation. In fact, recent analysis shows that there are complementarities between
national macroprudential policy and counter-cyclical fiscal policies, which limits the burden
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placed on either policy instrument if both are simultaneously deployed. Through such
mechanisms, the impact of internal spillovers within the monetary union and any potential
financial stability side effects of the area-wide common monetary policy can be mitigated.
Conclusions
In summary, the focus of this speech on external and internal spillovers serves to illustrate the
analytical challenges in determining the optimal monetary strategy for the ECB and the
appropriate set of domestic ancillary policies for the member countries of the euro area.
Information exchange and the sharing of analysis across the global central banking community
through fora such as the bimonthly meetings of governors at the Bank for International
Settlements and the biannual meetings of the International Monetary Fund provide a valuable
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common platform in assessing and evaluating external spillovers. Equally, in relation to internal
spillovers, the work of the Financial Stability Committee of the ECB and European Systemic Risk
Board provides a framework to develop a shared analysis of financial stability risk within the euro
area and, more broadly, across the EU.
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References
Aguiar, Mark and Gita Gopinath (2007), "Emerging Market Business Cycles: The Cycle is the
Trend," Journal of Political Economy 115, 69-102.
Ammer, John, Michiel De Pooter, Christopher Erceg, and Steven Kamin (2016). "International
Spillovers of Monetary Policy," International Finance Discussion Note 2016-02-08, Board of
Governors of the Federal Reserve System.
Bruno, Valentina and Hyun Song Shin (2015), "Cross-Border Banking and Global Liquidity,"
Review of Economic Studies 82(2), 535-564.
Caballero, Ricardo J., Emmanuel Farhi and Pierre-Olivier Gourinchas Pierre-Olivier Gourinchas
(2015), "Global Imbalances and Currency Wars at the ZLB," NBER Working Paper No. 21670.
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"ECB-Global: Introducing ECB's Global Macroeconomic Model for Spillover Analysis," ECB
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Journal of the Statistical and Social Inquiry Society of Ireland XLIV, 40-68.
Lane, Philip R. and Gian Maria Milesi-Ferretti (2017), "International Financial Integration in the
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1
I presented earlier versions of these remarks at the CFS-IMFS "ECB and Its Watchers XVIII" Conference on the
6th of April and the IBRN-IMF "The Transmission of Macroprudential and Monetary Policies Across Borders"
Conference on the 19th of April. I thank Mary Everett, Donata Faccia, Garo Garabedian and Rebecca Stuart for
their inputs to this speech.
2
In addition, the strategy includes reinvestments of the principal payments from the maturing securities
purchased under the asset purchase programme.
3
See, amongst many others, Bruno and Shin (2015) and Lane (2016).
4
A wider measure of the nominal effective exchange rate for the euro area is highly correlated with the dollar-euro
rate.
5
I emphasise the impact of the exchange rate on activity levels, since the direct impact on the consumer price
level is very limited for a continental-sized economy. The direct effect of the exchange rate on the price level is
much more significant for small open economies.
6
Casas et al (2016).
7
For instance, see Aguiar and Gopinath (2007) on the volatility of emerging economies.
See, amongst others, Ammer et al (2016), Carney (2016) and Dieppe et al (2017).
9
For instance, see Carvalho and Fidora (2015).
10
Caballero et al. (2015).
11
See Eichengreen (1993) on the political economy problems associated with material shifts in intra-EU bilateral
exchange rates.
12
The category of internal spillovers also includes intra-area contagion effects of financial crises in individual
member countries. The analysis of crises is beyond the scope of this speech.
13
Macroprudential policies also have a role to play in addressing the common component in the euro area
financial cycle, in view of the costs associated with deploying monetary policy to manage financial stability risks.
14
Martin and Philippon (2017).
15
See Draghi (2016).