Lorenzo Bini Smaghi: Three questions on monetary policy easing
Lecture by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the University of Ancona, Ancona, 6 March 2009.
* * *
1. Introduction1
It is a pleasure to be at the University of Ancona and to be able to deliver this lecture. Thank
you very much for the invitation.
When preparing this lecture, I found myself thinking about the speech I gave in October
2006. At that time, central banks worldwide were raising interest rates, so I thought it would
be useful to consider the key challenges that monetary policy faced in a tightening phase. I
asked the following three questions: When to start tightening monetary policy? At what speed
to tighten? And when to stop tightening?
Circumstances have changed. Now, central banks worldwide are lowering interest rates. So
we could ask the same questions, but just change one word: When to start easing monetary
policy? At what speed? And when to stop easing? Today I would like to share with you some
thoughts on these three questions.
In theory, the answers to the three questions should be simple. A loosening phase begins -
and the interest rate should be cut - when downward risks to inflation prevail. The interest
rate should be cut at a pace necessary to ensure price stability in the medium term. Finally,
the easing phase should end when upward risks to inflation become dominant again. In the
euro area, the downward or upward risks to inflation refer to the ECB's definition of price
stability, which is less than, but close to, 2%.
This may sound easy, in theory. In practice, how do you decide if upward or downward risks
to inflation predominate? There is no silver bullet, no single indicator and no single model
that can do the job for monetary policy-makers. Any modern central bank looks at a variety of
indicators, at a variety of models, and uses careful judgement to reach a firm view
concerning risks to price stability. At the ECB, as you know, we find it useful to organise the
analysis of risks to price stability on the basis of two complementary perspectives. First, in
what we call the "economic analysis", we assess the short to medium-term determinants of
price developments. The focus is on real activity, price indexes and financial conditions. The
second perspective, the "monetary analysis", focuses on the medium to long run. Here we
explore the medium to long-run link between monetary and financial variables and
inflationary pressures in order to cross-check the economic analysis. We employ this
twopillar strategy when forming a view on whether upward risks or downward risks to price
stability predominate; and when forming a view on whether the interest rate should move.
Regardless of the phase, the analytical process remains essentially the same - at the
beginning of the loosening phase or in the middle of it or even when we are about to decide
to begin raising the interest rate. We adhere to the same principles whenever we make an
interest rate decision. We do so because we believe that monetary policy is about a
continuous commitment to price stability over the medium term.
2. Forward-looking monetary policy
Let me start by recalling why the conduct of monetary policy is more complicated in practice
than it may seem in theory. The key factor relates to the transmission lags of monetary
policy. It is the time that it takes for changes in the interest rate to have an impact on other
economic variables, in particular inflation, which amounts to several months. That the
transmission lags of monetary policy are significant is one of the best-known, most robust
findings of monetary economics. It is a finding supported by evidence from different
countries, from different monetary regimes, and is based on alternative empirical
methodologies.
Milton Friedman used perhaps the simplest methodology to suggest that the transmission
lags of monetary policy are significant. In a paper published in 1972, he considered
correlations between changes in monetary aggregates and changes in industrial production
and in consumer prices indexes.2 He did so for a range of leads and lags, using data from
the United States. Friedman's main finding was that the highest correlation for industrial
production was for the monetary aggregate M1 leading by three months and for M2 leading
by six months. Furthermore, the highest correlation for consumer prices was for M1 leading
by 20 months and for M2 leading by 23 months. Friedman reported this evidence almost 40
years ago. It is remarkable that recent evidence confirms his findings. In the United States
and in the United Kingdom, there is a lag of one to two years between changes in monetary
aggregates and changes in inflation.3 In the euro area, the low-frequency component of M3
growth leads the low-frequency component of HICP inflation by about two years.
Techniques more sophisticated than Friedman's also suggest that changes in the interest
rate have the strongest impact on the economy with a delay. I refer here to structural vector
autoregression models, VAR models, and to dynamic stochastic general equilibrium models,
DSGE models. The results from structural VARs for the euro area are in line with the findings
based on data from the United States and elsewhere.4 Peersman and Smets, in a volume
devoted to the transmission of monetary policy in the euro area,5 find that an increase in the
interest rate is followed by a fall in output after about two quarters. The effect on output is
strongest after about three to five quarters. The price level responds even more sluggishly
than output. Furthermore, it appears that the price level responds more slowly in the euro
area compared with the United States. This is something you would expect, given that prices
of individual goods and services appear to change less frequently in the euro area compared
with those in the United States.6 DSGE models estimated from euro area data arrive at
results broadly in line with those from structural VAR models. For example, the model by
Smets and Wouters shows hump-shaped responses of output and inflation to a change in
the interest rate, with the strongest effects occurring with a delay similar to that found in VAR
studies.7
The lags between changes in the interest rate and their impact on the economy appear to
remain approximately constant over time and across different monetary policy regimes. For
the euro area, Peersman and Smets find that they cannot reject the null hypothesis, namely
that, since the early 1970s, the response of the economy to monetary policy has remained
unchanged.8 It might be possible that Economic and Monetary Union (EMU) has caused
changes in the transmission mechanism and that such changes are too recent to be detected
in statistical analysis. All we can say so far is that the available evidence points towards the
absence of significant changes in the transmission mechanism. For example, a recent paper
by Boivin, Giannoni and Mojon reports no significant changes in the transmission of
monetary policy to inflation since January 1999.9
To sum up, given the lags in the transmission of its effects, monetary policy has to be
forward-looking. A central bank has to try to forecast as well as it can developments in the
economy over the so-called "policy-relevant horizon". It also has to try to detect the risks to
price stability and decide the appropriate level of interest rate to achieve its objective.
3. When to start monetary easing?
On the basis of the analytical framework described above, any loosening of monetary policy
should in theory start before the cyclical downturn; it must start before economic activity falls
below its potential level. But to start the loosening cycle inflation expectations need to be
firmly anchored, in line with the central bank's definition of price stability. If interest rates are
reduced in a context of rising inflation expectations, there is a risk of dis-anchoring them
which would jeopardise the effectiveness of the policy move. This refers to expectations
prevailing not only in the financial markets but also in the goods and labour markets. In the
financial markets, an increase in inflation expectations would lead to a higher long-term
interest rate, possibly also in real terms, which would discourage investment - precisely what
the monetary easing did not intend to achieve. In the goods market, if a cut in the interest
rate were made while producers' pricing expectations remained high, or were even
increasing, it would further encourage mispricing behaviour in the face of a slowdown and
would in fact exacerbate it. In the labour market, if wage behaviour were based on excessive
inflation expectations, a rate cut could justify such expectations and excessive increases in
remunerations, which would be a development out of line with the growth slowdown ahead.
Therefore, the timing of any policy easing has to be linked to inflation expectations, in
particular longer-term ones. A central banker has to extract information from a series of
indicators, relating to the financial market, professional forecasts, pricing behaviour by
companies and by wage developments. The slower inflation expectations adjust to the
economic slowdown, the slower the central bank will adapt monetary conditions to the
projected decrease in inflation risks over the policy-relevant horizon. In other words, it is not
enough for the central bank to forecast accurately the slowdown of the economy, and the
associated reduction in inflation risks, for it to act promptly. The private sector also needs to
adjust its expectations accordingly.
A consequence of the above is that in countries where the private sector, in particular the
participants in the goods and labour markets, are less flexible in adjusting their pricing and
wage behaviour in the face of exogenous shocks, the central bank will be slower in easing
monetary policy when confronted with a slowdown. This might explain some of the
differences between monetary policy in the US and the euro area. In the former, where
markets are more flexible, the Federal Reserve may be able to cut interest rates in response
to the economic slowdown at an earlier stage, because that slowdown is expected to bring
about a rapid adjustment in pricing behaviour and expectations. In the euro area, however,
price and wages tend to follow the cycle with a lag, and tend to keep rising for some time
even after the slowdown starts.
Let us consider the most recent example of the start of the easing cycle in the fall of 2008.
The euro area economy was projected to slow down in the second half of 2008 already for
some time. For instance, in the ECB 2008 spring forecast, the euro area GDP growth was
projected to fall from 2.7% in 2007 to 1.8% in 2008 and 1.5% in 2009. However, in spite of
the projected slowdown, inflationary pressures continued to rise until the summer of 2008.
Headline inflation rose to 4%, on account of strong commodity price pressures. Long-term
inflation expectations derived from inflation-linked bonds increased in the course of the
spring, from levels slightly above 2% to levels above 2.5% in June 2008. Shorter term
forecasts from Consensus, the ECB's Survey of Professional Forecasters (SPF) and other
private sector forecasts, as well as forecasts from international organisations, pointed to an
inflation rate above 2% in 2009. Growth in compensation per employee also continued to
increase in the second and third quarter of 2008 at a rate above 3%, in spite of the expected
economic slowdown. Under these circumstances, a premature interest rate cut would have
signalled a passive acceptance of such behaviour, which would have translated into a further
misalignment of price and wage expectations with respect to the underlying fundamentals.
This would have made the current slowdown ultimately more severe.
In conclusion, with the benefit of hindsight, the easing cycle often seems to start too late.
However, this apparent delay is due to the rather inflexible adjustment of private sector
expectations and behaviour.
4. At what speed should monetary policy be eased?
This question gives rise to a related one: is there an asymmetry between a loosening phase
and a tightening phase? Should policy-makers react more strongly, and faster, to negative
deviations of the inflation forecast from the inflation objective, compared with positive
deviations?
Suppose that the economy was characterised by a linear structure, with slowdowns and
recoveries of similar intensity, and that the policy-makers' preferences have the form of a
quadratic loss function. In this case, the optimal behaviour of policy-makers should be
characterised by a linear response function: the interest rate would react proportionally to
deviations of inflation and the output gap from desired levels.10
In practice, we observe that monetary policy easing tends to be quicker and more decisive
than tightening. This means that one of the two simplifying assumptions mentioned above
does not hold. Let's consider first the policy-makers' preferences. An argument which is
sometimes advanced in support of asymmetric central bank behaviour is political pressure on
central banks, which might be stronger during an economic downturn than at a time of
inflationary pressure.
Cukierman and Gerlach show formally how inflation bias in monetary policy can arise due to
the combination of asymmetric concerns about positive and negative output gaps, and
uncertainty about the future state of the economy.11 This observation could explain why the
loosening phases of monetary policy reductions are generally quicker than the tightening
ones. They obtain this result despite the fact that, in their model, the central bank's desired
level of economic activity is the same as potential output. This is in contrast with the
traditional literature, which derives inflation bias based on "time-consistency" arguments,
related to the fact that the central bank targets a level of economic activity which is above
potential output.12
Cukierman and Gerlach find support for their theory using data from 22 OECD countries.13
This hypothesis nevertheless does not seem to be fully convincing for independent central
banks. Surico (2007), for instance, produced evidence suggesting that the Federal Reserve
exhibited asymmetric preferences only until 1979, with a stronger reaction of the interest rate
to output contractions than to output expansions.
In discussing his experience as Vice-Chairman of the Fed, Alan Blinder seems to suggest
the opposite: "...in most situations the central bank will take far more political heat when it
tightens pre-emptively to avoid higher inflation than when it eases pre-emptively to avoid
higher
unemployment".14 This is also consistent with my own experience. There were many
more pressures on the ECB - not only from political authorities but also from academics - at
the start of the tightening cycle, at the end of 2005, than during the loosening cycle of the last
few months. Needless to say, such pressures have obviously no impact on the conduct of
monetary policy. Independent central banks are used to hearing but not listening, as Wim
Duisenberg once said.
The alternative hypothesis is that the business cycle itself is asymmetric. Wesley Mitchell, a
pioneer of business-cycle analysis, wrote in 1927: "...business contractions appear to be
briefer and more violent than business expansions".15 Modern economic analysis, based on
data from the United States, confirms that contractions in employment tend to be more
abrupt than expansions.16 Furthermore, cyclical downturns may be associated with financial
market turbulence and blockages in some segments of the financial market. Under these
circumstances, it is appropriate for the central bank to ease monetary policy quite rapidly, in
line with the expected slowdown of the economy.
If inflation expectations remain well anchored during a downturn, it might be preferable to err
on the side of quick and large reductions in the interest rates than on the side of gradualism.
A key question in this respect is how far down to go - an issue I'll consider next. But
assuming that the central bank has a view on the appropriate level, it is preferable to reach it
sooner than later. The reason is that the stimulatory effect of a rate cut is limited if agents
expect the central bank to implement further cuts. Agents may delay their borrowing
decisions for investment or consumption purposes until interest rates reach the lowest level.
On the other hand, the rate which matters for investment or borrowing decisions is not
necessarily the very short-term one. Longer-term rates also matter. An undesirable outcome
of a decision to lower the policy-relevant interest rate would be to lead to an increase in the
long-term ones, especially if it is so in real terms. This would discourage investment and
penalise agents holding longer-term risky assets.
To avoid such a problem, any policy rate cut has to be justified on the basis of the prevailing
monetary policy framework. Any departure from such a framework, through erratic and
unexpected behaviour, would risk being misinterpreted by economic agents and be
associated with a change in the underlying approach to monetary policy. If this happened,
the predictability of monetary policy, which is an important asset for central banks, would be
undermined. For instance, sharp unexpected cuts in interest rates might lead market
participants to expect more cuts in the future. They might also fuel expectations that the
central bank has more (negative) information on the underlying economic developments or
on financial market risks than market participants. This might aggravate pessimistic
expectations about economic and financial conditions, more than would be justified by the
facts.
Over recent months the deterioration in economic conditions, as reflected by the sharp fall in
all leading indicators, and the rapid decrease in inflation, has created room for fast and
substantial cuts in interest rates. The ECB has cut its key policy rate by 275 basis points
since October last year. It has done so with unprecedented moves, including one move taken
outside the regular monetary policy meetings. But it has also done so within its traditional
monetary policy framework, in order to provide market participants with the appropriate
analytical anchor to understand its decisions.
Another issue to take into account is the transmission of the easing impulse of monetary
policy to the rest of the economy. It is not sufficient that the policy rate is reduced to ensure
that monetary conditions are eased accordingly; the stance of monetary policy has to be
measured also on the basis of overall financing conditions. The monetary transmission
mechanism might be impaired, in particular because of financial instability or problems
incurred by the banking sector. Under these circumstances, it is not sufficient to ease
monetary policy by lowering official interest rates. Measures aimed at improving the
transmission of the monetary impulse to the rest of the economy need to be implemented, in
order to affect the interest rates that are really relevant for borrowing and lending.
Improving the functioning of the financial market is not a task that can be achieved by the
central bank only. Central banks have adopted in recent months measures in this direction. I
will not try to summarise what the ECB has done in this field, and what it intends to do in the
future. However, without a more decisive action by the fiscal and by the supervisory
authorities to recapitalise the banking system and ensure more transparent accounting and
loss recognition, the transmission mechanism will continue to remain impaired, thereby
hampering the effectiveness of monetary policy. This is a risk for the credibility of central
banks. I also see a risk that the other authorities hide behind the activism of the central
banks and shirk from their own responsibilities.
The current situation is certainly a good example of how a very accommodative monetary
policy stance in major industrial countries, aimed at supporting economic activity and
maintain price stability, is partly impaired by financial market distress, in particular in the
interbanking market. For instance, in the US, while the overnight rate is close to zero, the
3month Libor rate, which is a key rate in the transmission mechanism, is around 1.3%, in line
with the 2003-2004 period. In the euro area, the 3-month Euribor rate has progressively
fallen to a level slightly below the ECB policy rate, which was 2% until yesterday, and in line
with the levels prevailing in 2003-2005. After yesterday's decision to reduce policy rates to
1.5%, the 3-month Euribor rate is expected to fall to a level very close to the one prevailing in
the US. The overnight rate will also fall, presumably to levels just above 0.5%.
5. When to stop easing?
Finally, let me turn to the last of the three questions on monetary policy loosening: when to
stop? This is like asking: what interest rate level should mark the floor of an easing cycle?
The standard literature would suggest that the answer to this question depends on forecasts
about the slowdown of the economy and the underlying inflationary pressures. The greater
the output gap and the lower the inflation expectations, the more the interest rate should be
cut to support the economy while maintaining price stability. The literature has rationalised
such a relationship with the estimate of reaction functions or Taylor rules.17
In recent years, the discussion has been pushed further, with the suggestion that, given the
uncertainties surrounding forecasts and estimates of output gaps and inflation, it might be
appropriate to bring the policy-relevant interest rate substantially below the level consistent
with the output gap and inflation, even to zero, its natural floor. Following this argument, as
soon as the economy is hit by a negative shock monetary policy should err on the
expansionary side, this risk being more acceptable than the opposite one, and this could
contribute to bringing output rapidly back to a level consistent with potential. As output starts
moving back to potential, the interest rate would then be increased again, back towards its
longer-term level.
This view is based on the assumption that a rate cut to an extremely low level would have no
counterargument and would actually enable the economy to recover more quickly. It also
assumes that when the economy starts recovering, the central bank would face no obstacles
to increase rates quickly enough to avoid fuelling inflation.
In this regard, some observations are useful. First, a policy which consists of cutting rates to
very low levels and then increasing them rapidly as the economy reaches the trough of the
cycle might not be very effective in supporting economic activity. Agents might be induced to
borrow more aggressively when interest rates are at zero, since borrowing conditions can
only worsen thereafter. Yet, if the main problem faced by the economy is insufficient lending,
for instance, because of weak confidence in the banking sector, rather than insufficient
borrowing, what matters most for the recovery is to convince savers to hold risky long-term
assets to finance the banking system and the real economy. When rates are at zero, or close
to zero, the likelihood that interest rates will move up increases, especially if the central bank
is committed to increasing rates as early as needed. Such a rate increase would penalise
those on the lending side who have invested in risky long-term assets, as they would suffer a
capital loss. A policy of very low interest rate levels favours borrowers but penalises lenders,
and if the economic crisis is associated mainly with a lending crisis, a policy of extremely low
interest rate might be counterproductive.
If the rate cut stops at a higher level, consistent with the medium-term inflationary
projections, it is more likely that the interest rate will remain at that (above zero) floor level for
some time and lenders will be more inclined to invest in long-term risky assets. It might seem
paradoxical, but a policy of persistently low interest rates might be more credible at a slightly
higher level of interest rate than at zero. The ECB's announcement that it will provide fixed
rate liquidity allotments at unlimited amounts for a prolonged period should also contribute to
the effectiveness of this signal.
An excessively low level of interest rates may also have some unintended consequences in
financial markets. It might drive some financial intermediaries out of business, for example
money market funds having small, but strictly positive investment fixed costs and not
anymore in the position to offer positive net returns to risk averse investors, thus risking large
redemptions. It could also trigger a disorderly unwinding of investment in certain securities,
causing mis-pricing in other market segments. This problem could be more serious in a
situation in which large parts of the financial system are already distressed.
I would also like to emphasise that even at zero rates the central bank can stimulate lending
by entering directly into the credit market, making up for the absence of lenders and buying
long-term assets.18 This however implies that the central bank is willing to take the capital
losses that are likely to emerge when interest rates are increased again. Furthermore,
monetary policy becomes blurred with fiscal policy and risks crowding out the functioning of
the private capital markets. In any case, its effectiveness in lowering long term interest rates
and thus inducing other agents to buy risky assets has to be demonstrated.
Another way to avoid the first problem mentioned above is for the central bank to convince
market participants that they will not suffer capital losses because interest rates will remain
low for a prolonged period of time. Agents might tend to have such expectations if they
foresee the economy remaining in recession for a protracted period or if they project
deflationary pressures ahead. This would be reflected in a flat yield curve and low long-term
rates. However, if the yield curve does not reflect such deflationary expectations, the central
bank may try to flatten it by committing to maintain low interest rates for a prolonged period
of time, and may try to convince agents that they can safely invest their savings in long-term
assets without incurring in capital losses. Yet such a policy may encounter a series of
additional problems.
By committing to keep rates low for a prolonged period of time, the central bank is effectively
reneging on its promise of raising rates as quickly as possible once the trough of the cycle
has been reached. De facto, the policy of cutting rates to zero and then raising them quickly
is not time-consistent. After rates have been cut the central bank has an incentive to keep
rates low for some time to encourage agents to invest in risky assets. Any such
inconsistency between what is signalled or announced and what is delivered ex post can
undermine the credibility of the central bank and hamper the transmission of monetary policy.
Furthermore, such a policy is a prologue to maintaining low rates for a very long time,
possibly too long, thus favouring the formation of a new bubble. Indeed, when rates are
increased again the holders of long-term assets are hit by a capital loss, thus negatively
affecting the economy. The incentive is to delay such a hit until the economy is well on the
way to recovery, thus avoiding to "rock the boat". Central banks are often accused of
increasing rates too early. In 1994 even the Fed's modest interest rate increase was heavily
criticised by financial markets, as it led to a sharp increase in market volatility and substantial
losses for many market participants. In December 2005, when the ECB increased rates after
holding them at 2% for over two years, politicians, academics and commentators criticised
the decision, presumably on the grounds that it would undermine the recovery.19 This is not
to say that central banks should not stand ready to reduce interest rates when needed, even
to very low levels, but to suggest that, the longer they wait to raise rates when the economic
situation so requires, the sharper will be the impact on the financial markets and thus on the
economy.
Finally, bringing rates to zero and committing to keep them there for as long as needed, even
while agents rule out a deflationary scenario, suggests that the central bank knows more
than the private sector about deflationary risks. This message is risky and might be
misinterpreted by market participants, who might then reconsider their own expectations,
thus increasing the probability of deflation. This could disanchor expectations and increase
the probability of the worst-case scenario materialising.
To sum up, cutting rates to zero, or to a level below what would be justified by the underlying
fundamentals can lead to substantial problems. Overall, policy-makers have to balance type I
and type II errors, and their potential implications. The type I error is to underestimate a
deflationary scenario, and keep rates too high, which would further exacerbate deflation. The
type II error, in contrast, is to attach too high a probability to a deflationary scenario which is
not on the cards, and to cut interest rates to a very low level, even zero. This would then
create the next bubble and unleash a new crisis. Some would suggest that the type I error is
always the gravest, with the most serious consequences for the economy, while the type II
error can be more easily corrected. The arguments developed above show that type II errors
can be just as grave and are not so easily reversible.
Empirical evidence seems to support that type II errors are not uncommon. In particular,
Jarociński and Smets (2008) estimate a VAR model for the US, using real GDP, the GDP
deflator, the federal funds rate, and so on, to answer the following two questions.20 First,
"Was US monetary policy excessively expansionary at the beginning of this millennium?" In
other words, was the federal funds rate kept low for too long between 2002 and 2004, on
average, given the circumstances prior to that period? The answer is "Yes". The second
question is, "Did this expansionary monetary policy cause a part of the housing boom in 2004
and 2005?" Again, the answer from the VAR model is "Yes". Putting the two answers
together, we see that easy monetary policy prompted by the perceived risks of deflation
between 2002 and 2004 contributed to the housing boom in the years thereafter. And, I
would add, the crisis we are currently in is the result of the bursting of that bubble.
Obviously, we should be careful in interpreting these results. But they have been confirmed
by other research.21 To be sure, these results are obtained with the benefit of hindsight. It is
certainly possible - even likely - that, had the extent of the housing bubble been known two,
three years ahead, the interest rate decision would have been different. On the other hand,
this suggests that we should learn from the experience of the last decade.
This doesn't mean that policy-makers should not stand ready to cut rates to a very low level,
even to zero, if the underlying conditions in the economy justify it, in particular if the economy
is really on the verge of persistent deflation. And in such a case it is better to do it sooner
rather than later. However, if the economy is not in that predicament, cutting rates to a very
low level, even to zero, just to insure against the worst case scenario can have deleterious
effects in both the short and long term.
6. Conclusions
To conclude, I have analysed today three questions that policy-makers have been pondering
in recent months. The answers can be summarised as follows: first, start cutting rates when
you see growth slowing down but not before inflation expectations abate towards the
objective of price stability; second, cut rates quickly, but within a credible monetary policy
framework; third, be careful to avoid overshooting and cutting interest rates to too low levels.
To be sure, any decision on the easing of monetary policy, i.e. when to cut rates, how
quickly, and to what level, has to be based on an assessment of the underlying and projected
economic developments. I do not believe it is sound to always err on the side of excessive
easing, and to insure against the worst-case deflationary scenario, even when such a
scenario is unlikely to ma