Peter Praet: Calibrating unconventional monetary policy
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at The
ECB and Its Watchers XVIII Conference, organised by the Center for Financial Studies and the
Institute for Monetary and Financial Stability at Goethe University Frankfurt, panel on the
"Assessment of the expanded asset purchase programme" (with John Taylor and Jan Hatzius),
Frankfurt am Main, 6 April 2017.
* * *
I would like to thank Federic Holm-Hadulla for his contribution to this speech.
The ECB's monetary policy stance is currently driven by three main mutually reinforcing
instruments: a negative deposit facility rate; an expanded asset purchase programme covering a
broad range of private and public securities (APP); and an integrated system of forward guidance
that governs the future path of asset purchases and short-term interest rates, as well as the
sequencing of these different policy tools. Moreover, the targeted longer-term refinancing
operations, the last of which was conducted in March, will continue to incentivise bank lending
over the next four years.
These measures have supported financial conditions, which - due to their prominent role in the
transmission of policy impulses - act as a crucial intermediate variable in the pursuit of a
stability-oriented monetary policy. However, while the role of financial conditions in the
transmission process has remained as relevant as ever, the task of steering them in line with
domestic macroeconomic policy objectives has become more challenging in view of the
manifold dislocations in financial markets that have arisen since the crisis and the proximity of
standard policy instruments to their lower bound. The ECB's unconventional measures have
confronted these challenges and ensured an appropriate degree of accommodation by fostering
very favourable financing conditions.
Our monetary policy is working, and we see that, supported by our mutually reinforcing monetary
policy measures, the euro area economic recovery is steadily firming. The cyclical recovery is
gaining momentum and the expansion is broadening across sectors and countries, showing the
effectiveness of the transmission of our measures throughout the entire euro area economy. Yet,
the risks to the growth outlook remain tilted to the downside, even though their balance is
improving. And, importantly, inflation dynamics continue to be conditional on the present, very
substantial degree of monetary accommodation.
In calibrating the set of monetary policy instruments, we faced - and we still face - two issues.
The first, which I will refer to as the measurement issue, consists in quantifying the overall
amount of monetary policy support that we are providing and parsing that support down to the
individual instruments. In unconventional monetary policy times, measuring the contribution of
each instrument to the stance is crucial to ensuring an appropriate composition of the policy
toolkit - a challenge that is much less pronounced in conventional times when the decision
space focuses on policy-controlled short-term interest rates as the one, dominant, tool to steer
the stance. Measuring the marginal contributions of each instrument is very hard however.
The second issue, which I will refer to as the benchmarking issue, consists in determining
whether the resultant, overall monetary policy support is appropriate, i.e. commensurate with our
assessment of the state and expected evolution of the economy; and, if any changes are
necessary, what specific instrument in our multi-pronged policy strategy needs to be adjusted.
In today's speech, I will review these different challenges and describe the ECB's approach to
addressing them.
Measuring and benchmarking monetary policy
To operationalise the intended policy path, it is crucial to form an assessment of the prevailing
stance.
Here, economists have traditionally resorted to two types of indicators. One consists of policy
rules that exploit the systematic relationship between a monetary-policy controlled short-term
interest rate, in deviation from some medium-term equilibrium value, and a set of
macroeconomic variables, typically including inflation and economic slack - as in the eponymous
Taylor rule. Given an assumption for the medium-term equilibrium interest rate norm, these rules
promise to deliver a level of the short-term rate that would be consistent with driving the economy
back to a sustainable non-inflationary path starting from current macroeconomic conditions.
The other type of indicator consists of Financial Conditions Indexes (FCIs) that synthesise
potentially large numbers of financial variables and weight them based on how well they forecast
future (nominal or real) economic activity or how much of the common variation of the individual
constituent variables they explain - a field to which Jan Hatzius has made important
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contributions.
The simple benchmarking flavour of the Taylor rule and the broad, encompassing metric of
accommodation offered by the FCIs represent a valuable disciplining tool from which one can
start to reflect about the prevailing stance and the way the stance should be adjusted as new
information flows in.
FCIs, in particular, can facilitate story-telling. They have also been able to broadly track the most
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salient, yet not all, phases of the recent crisis. Overall, they show a positive trend in financial
conditions since 2009, reflecting the policy response to the crisis. This was preceded however
by a tightening in financial conditions in 2007 and 2008 on the back of investor panic and
contagion effects that spilled over across the entire array of asset prices at the height of the
crisis. The FCIs also show the subsequent reabsorption that took place in the aftermath of the
forceful response by central banks and other policy actors around the globe (see their evolution
in the span of time marked by the shaded area for the "global financial crisis"). Furthermore, they
document the renewed tightening in euro area financing conditions that was heralded by the
escalation of the sovereign debt crisis in the spring of 2010. More recently, the FCIs point to a
clear footprint of the non-standard monetary policy measures the ECB adopted since mid-2014,
after the rate cuts over the preceding two years had coincided with broadly unchanged financial
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conditions. Yet their improvement from end-2011 onward stands in contradiction with the
escalation of the sovereign debt crisis, a point I come back to shortly.
Both approaches, FCIs and policy-rules, encounter challenges regarding both the inference that
they suggest concerning the quantum of monetary policy accommodation prevailing at any
specific point in time (their measurement function) and the prescriptive value that one can extract
for calibrating current and future policies (their benchmarking function). I believe one can say that
their dual informative value is degraded particularly in the wake of major dislocations - in financial
markets and in the functioning of the economy more broadly - of the sort we had to confront in
the recent past.
Financial conditions indexes
Let me make this point specifically with regard to FCIs and, for that purpose, let me comment on
Chart 1. I concentrate on the period prior to July 2012, when Mario Draghi gave in London a
speech which is widely credited for stemming the panic that had been raging for a whole year in
the euro area financial markets. The panic - by any measure - had already impaired firms' and
households' access to credit in broad regions of the currency union to an extent that was
damaging macroeconomic stability in systemic proportions. And it had induced a pronounced
impairment in monetary policy transmission. This was visible for instance from bank lending
rates which, despite a series of cuts in monetary-policy controlled short-term interest rates,
remained stubbornly high and only started entering a pronounced and durable downward
convergence path around the time in which the ECB adopted its credit easing measures in
mid2014 (see Chart 2).
But, while this sequence of events and causative influences is well-documented empirically, the
picture that emerges from the FCIs is somewhat different. According to the indicators shown in
Chart 1, conditions seem to have been loosening - not tightening - in the 6 months prior to the
time of the speech. While conditions eased further, more or less in correspondence of the event
in July 2012, that further shift in the range of financial condition indices is marginal if contrasted
with its upward trend that had occurred before.
How can this be explained? The explanation mainly resides in the large weight that these
indicators tend to assign to the exchange rate for averaging across financial market variables.
The dramatic bout of risk aversion and pessimism about the sustainability of the euro area,
which pre-dated the speech, had encouraged a massive reallocation of international portfolios
away from euro area assets, and this capital flight had led to a material depreciation of our
currency. Was this depreciation a net source of accommodation in the months preceding the
July speech? Or wasn't it rather the reflection of an underlying and pervasive re-appraisal of
break-up risk which would restrain consumption and business investment for years to come and
remain a lingering factor weighing down on the recovery to this day? I tend to conclude in favour
of the latter interpretation, which also shows that careful judgement needs to be exercised when
interpreting FCIs, particularly at times of dramatic financial disruption.
We can generalise this message beyond episodes of heightened financial stress. By weighting
different variables - such as the exchange rate, equities and interest rates - by their estimated
impact on important macroeconomic aggregates, FCIs promise to offer a way to identify an
"equivalence scale", on the basis of which one can weigh the importance of one financial variable
against the importance of another in maintaining a certain degree of looseness/tightness. But we
should be wary of over-stretching this notion to mechanical prescriptive implications, because
this can inspire unwise policy conclusions. A given level of the FCI can be delivered by many
different combinations of drivers and underlying forces, which make the mapping between that
particular level and the broad stance of policy an elusive task.
Let me make another example that is valid in abnormal and more tranquil times alike. An
increase in long term rates can be a purely exogenous rate shock, if they merely reflect the
tendency of domestic yields to fluctuate in synch with international yields; or it can reflect more
optimistic expectations concerning the state of the domestic economy. The stance implications
of these two scenarios are vastly different.
An interesting case study emerges from the global shifts in financial market sentiment since
autumn 2016. An attempt to disentangle different drivers of key financial market variables
exploiting cross-asset correlations (see Chart 3) shows that global factors may have been
exerting strong influence on euro area financing conditions, with tightening pressures on real
interest rates (see left panel). At the same time, part of the increase in real rates over this period
would be reflecting the ongoing improvement in euro area macroeconomic conditions, which
also supported equities (see right panel). And the upward impacts on real interest rates would
have been offset by domestic monetary policy, thus partly insulating euro area financing
conditions from the tightening pressures originating from abroad. The relevance of different
drivers entails an important caveat against a mechanical interpretation of changes in FCIs.
This is not the only caveat however. Of course, timeliness is a practical advantage of these types
of FCIs, which are based on high-frequency financial market information that can be tracked on a
daily basis. In the euro area, however, this timeliness may conflict with the relevance of
measuring broader financing conditions that account for the availability and pricing of bank
lending. Given the bank-based financing structure of the euro area, such indicators are essential
to assessing the transmission of monetary policy. But they are only available at a significantly
lower frequency and - even in normal conditions - the transmission of policy impulses to bank
lending conditions is more sluggish than to the financial market variables typically included in
FCIs, such as equity indexes or exchange rates. This is why FCIs can only provide a partial
picture of prevailing financing conditions that needs to be complemented with further sources,
including inter alia an in-depth analysis of monetary and credit developments as embedded in the
second pillar of the ECB monetary policy strategy.
Another caveat derives from the considerable uncertainty surrounding the appropriate weighting
of individual constituent variables. Conceptually, it appears attractive to base such weighting on
the impact that exogenous variation in each of these variables would exert on relevant economic
aggregates, such as growth or inflation. Practically, however, such impact estimates are wrought
with a host of complex identification issues.
Finally, when using FCIs to track the evolution of financing conditions as an intermediate target,
policy-makers have to be mindful of differences in the controllability of its individual components.
In normal conditions, when monetary policy uses short-term interest rates as its dominant policy
tool and builds on a broadly predictable connection between these rates and broader financing
conditions, it is relatively straightforward to steer and assess its intermediate target. However, in
crisis times - when the link between short-term interest rates and broader financing conditions is
weakened and monetary policy increasingly relies on more direct means to affect a broader
range of financial variables - it becomes significantly more complex to assess the impacts of the
various monetary policy measures.
More granular model-based evidence suggests that the ECB's non-standard monetary policy
measures have left a clear footprint in euro area financing conditions. In particular, they have
induced a broad-based easing that spread across a variety of asset classes, including to bank
lending rates (Chart 4). As a consequence, notwithstanding the pronounced influences from
abroad, the ECB has been successful in managing domestic financing conditions through its
monetary policy measures.
Moreover, the impact of these more recent measures has been further supported by the
effectiveness of our forward guidance. One potential metric for this effectiveness is the sensitivity
of forward rates to macroeconomic news: in the presence of clear guidance on the policy rate
path, market expectations should be less reactive to the ongoing macroeconomic news flow and
instead be anchored by central bank communication. Observing this metric over time, it
becomes clear that the introduction of our measures - including the forward guidance on policy
rates - has been followed by a pronounced decline in the sensitivity of forward rates at the
shorter end of the term structure, which is most prominently driven by monetary policy
expectations, while remaining anchored around their historical average at the longer end (Chart
5).

My overall conclusion is that FCIs offer an information basis for measuring the quantum of
financial stimulus that is too fragile at times, and - more often than not - they do not provide a
robust benchmark for policy. To appreciate this last point, think of the example I just made. If the
dominant factor explaining the increase in long-term yields is foreign forces, the change would be
akin to a tightening and should counsel some offsetting monetary policy response. If the
dominant factor is the improvement in domestic macroeconomic conditions, policy forbearance
would be appropriate.
Finally, the connection between monetary policy and FCIs is a two-way road where, again,
financial conditions incorporate the whole set of monetary policy instruments put in place,
including forward guidance. Analysts thus have to account for the contribution of the existing
instrument constellation to changes in FCIs so as to avoid circularity between the signals of the
indicator and the conclusions on future policy conduct.
Monetary policy rules
Monetary policy rules, unlike FCIs, are designed to describe the systematic component of the
central bank's behaviour through time, and distil - from that behaviour - a broad paradigm for
prudent monetary policy conduct that is usable for calibrating policy going forward. Their
measurement scope is narrower than for the FCIs, as they concentrate on the very short-term
interest rate that is the main operating target of a central bank in normal times. But their explicit
normative focus and the link they establish between the policy instrument and the state of the
macro-economy is potentially of great value for assessing monetary policy.
But, again, while they can certainly help lay down a shared conceptual ground for economists to
start engaging in a disciplined conversation about the multiple trade-offs policy makers face and
the policy choices they should make to resolve them, they are less helpful as a ready-to-use
blueprint for policy design.
Why? Many central bankers, in past and more recent interventions, have emphasised
the measurement issues that impede a mechanical use of policy rules in the tradition of John
Taylor's famous benchmark. Prominent among these is the need to scale that rule to a level of
the short-term interest rate that is compatible with sustainable growth and price stability in the
medium term. That scaling factor, which has been referred to as the natural or the equilibrium
interest rate, is extremely influential in steering the policy implications that these rules can
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deliver. While hard to estimate, the literature gives clear indications that the natural rate may
vary over time and is likely to have fallen in recent years, due to declining productivity and
demographic factors, which in turn would lower the end-point to which monetary policy would
converge, once the economy is back to full capacity. I will not dwell on measurement issues
today, but rather concentrate on one aspect of simple monetary policy rules that has been
debated less intensely and concerns their usability as policy benchmarks in the day-to-day
reassessment of the policy stance.
As part of their strategies and tactics to fight risks of deflation and an environment of too low
inflation, in the past many central banks have reduced their traditional short interest rate
operating targets to levels close to their lower bound and have complemented the easing impulse
offered by these rate reductions with a host of other measures. The ECB has deployed a set of
mutually reinforcing instruments, including long-term conditional funding operations for banks,
negative short-term interest rates and direct outright interventions across the yield curve. Verbal
indications about the expected horizon of our purchases, and about the level and direction of our
policy interest rates looking into the future are also critical component of that strategy.
The non-standard ECB instruments can, to some extent, act as substitutes. For instance, APP
and the TLTROs both foster a rebalancing in banks' balance sheets toward loans - even though
the channels differ: APP promotes bank lending by lowering the return on banks' securities
portfolios, while the TLTROs produce the same outcome by increasing the risk-adjusted return
on loans.
When instruments are substitutes, one can indeed conceive of exercises in which the degree
and intensity with which each of them is applied is adjusted along an "equivalence frontier" of
sort, altering the mix of the policy package without necessarily changing the overall quantum of
stimulus that the entire policy package delivers. A Taylor rule could, in this case, assist in
benchmarking the level of the very short-term interest rate that is the traditional target of policy.
The remaining components of the policy package could thus be treated as a residual, after the
setting of the short-term interest rate is determined, and be calibrated such that they attain the
overall degree of accommodation indicated by the policy prescriptions originating from the Taylor
rule.
But, for the most part, our policy instruments act as strong complements. For instance, the
downward pressure that APP exerts on term premia is strengthened by the negative interest rate
policy and the rate forward guidance that offers an expected horizon for continuing that policy in
the near term. Negative remuneration on banks' excess reserves induces lenders and other
investors holding cash reserves to diversify away from liquidity into longer-dated assets. By
demonstrating that short-term interest rates can be driven to levels below zero, the central bank
can signal absence of non-negativity restrictions constraining the path of future short term rates
looking forward. This bends the whole predictive distribution of future short-term interest rates
down, which is another way of saying that the expectations channel of monetary policy and the
forward guidance on policy rates are reinforced. Conversely, APP empowers the forward
guidance on policy rates, as the credibility of indications about the setting of the policy rates in the
future are almost certainly enhanced by provision of asset purchases today. These purchases
are a concrete demonstration of a desire to provide additional stimulus. Clearly, forward
guidance on policy rates and APP are connected by a solid two-way interaction. That is: asset
purchases strengthen the signalling effect of rate forward guidance, while rate forward guidance
and the negative deposit facility rate reinforce the impact of purchases.
These strong complementarities among instruments mean two things. First, each instrument
within the policy parcel has a net value that would be diminished if used independently of - and in
isolation from - any of the other instruments. Second, the determination of the intentional horizon
for applying each of them can only be the result of an integrated decision process whereby these
intimate interactions are duly internalised.
I will now expand on the first aspect and try to bridge it to the problem that, in my view,
undermines the policy benchmarking function of simple policy rules in unconventional monetary
policy times like the present. At the end of my remarks, I will come back to the second aspect
and link it to the current debate on timing and sequencing of monetary policy normalisation.
At present, the intimate complementarity between asset purchases and the rate forward
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guidance makes monetary policy highly history dependent. The macroeconomic outcomes that
we observe today are as much the results of actions that we are taking at present, as the
ongoing lagged impact of the expectations that our past actions and communication have
generated. This is valid always and everywhere, because the signalling content of monetary
policy decisions is a predominant attribute of transmission. But it becomes a particularly crucial
aspect of policy in the wake of the major disruptions of the past years, which have set in motion
forces that still restrain the economy and will probably take more time to dissipate. The severity
and persistence of the shocks that have tended to destabilise the economy in the past few years
have forced a particularly bold, persistent and steady-handed approach to monetary policy. A
large part of what we do today is a follow-through on a course of action that was carefully charted
and communicated in the past. Likewise, a great deal of the macroeconomic outcomes that we
observe today is due to those plans, and the subsequent actions that have been enacted to carry
them out.
In this light, it becomes easier to appreciate how simple policy rules of the type John Taylor has
studied, if used outside a general equilibrium framework, can lead policy astray. The reason is
that, by design, they ignore the complementarities among instruments and they offer
prescriptions on one instrument as if it could be moved in isolation. And, if employed outside an
articulated "optimal control" framework, they are "memory-less", i.e. they forget about past states
of the world which may still be relevant for determining present-day conditions and monetary
policy actions.
To be more concrete, if used outside a model, these rules tend to prescribe a firming of policy as
soon as the economy starts improving. But, in the presence of non-standard measures, this
improvement arises precisely because of the set of policy initiatives that the central bank has put
in place in the past, including its rate forward guidance. A typical Taylor rule does not keep track
of the accumulated deviations of the target variables that arise from the limitations encountered
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by standard monetary policy at the lower bound. A deviation from the path of policy that is
consistent with our past communication is not only costly in terms of policy credibility in general.
It would also scale back an important source of stimulus that is behind the performance of the
economy that we observe today.
How can we retain the most attractive attributes of a Taylor rule - the fact that it encapsulates a
paradigm of robust and stability-inducing monetary policy conduct - and, at the same time,
address its limitations?
Many of the problems that plague Taylor rules can find solutions within a general equilibrium
framework where all the feed-forward and feed-back channels of interactions among policy
instruments, financial prices and the economy can be internalised in a consistent manner. In
fact, virtually all structural models - whether of a stochastic general equilibrium structure with a
strong forward-looking set-up, or of a more hybrid nature with a focus on time-series coherence
- are "closed" with a Taylor rule of one or another specification. Within those models in which a
Taylor rule "represents" monetary policy, the typical exercise that can answer the normative
issue is the following: how would inflation over the medium term horizon react if we were to
adjust our policy instruments, one at a time or all of them contemporaneously? This is the
philosophy behind our third criterion for declaring a "sustained adjustment in the path of inflation",
which is a pre-condition for starting to normalise our purchases and, indirectly, for starting to
normalise our policy rates - through the sequencing we expect to follow toward a more normal
configuration of policy.
Conducting this type of exercise today, we see that the combination of instruments that are
currently in place, including forward indications about the horizon over which these instruments
will still be used, is sufficiently supportive to put inflation on a rising path that will bring it to levels
close to 2% over a time frame that is compatible with our definition of medium term. But, and this
is our third criterion for a sustained adjustment, if we were to firm policy by scaling back the
stimulus provided, that inflation path would likely stall and relapse. The projected path of inflation
remains conditional on very easy financing conditions, for which monetary policy plays a key role.
Conclusions
In conclusion, let me return to the sequencing issue. Communication about the intentional
horizon of net asset purchases and expected future path of the policy rates is a key component
of the policy strategy that started in 2014. The reason is simple and, once more, has to do with
instrument complementarity. Above and beyond any signalling content they may have on the
intention of the central bank to provide accommodation, asset purchases add stimulus principally
by squeezing the term premia priced into longer-dated securities. However, absent reassurance
that policy rates will remain anchored around their lower bound for the entire life of the net
purchases, the impact of asset purchases may be partly neutralised. The downward impact of
purchases on long-term interest rates via compression of term premia will be offset by the
upward pressure that will stem from the steeper path of the expected short term interest rates.
Moreover, absent reassurance on the rate path, the term premium itself may increase if the
future course of the policy rates becomes more uncertain, despite the contrary effect of the
purchases. If investors start perceiving that the path of the policy rate is subject to upward
uncertainty, the compensation for interest rate risk - i.e. the term premium - will have to
increase. Again, long-term interest rates will be pushed higher and asset purchases will become
less effective.
These strong complementarities between instruments are behind the way the expected plans for
the evolution of APP and the policy rates have been lined up in time in the Governing Council's
intentions. In our expectation, the policy interest rate will remain at present or lower levels for an
extended period of time and well past the horizon of our net asset purchases. This forward
guidance implies a sequencing between the interest rate policy and the quantitative policy that
can most efficiently internalise and exploit the intimate complementarities between these two key
components of our current stance.
Sarasota, Florida.
2
The FCIs presented in Chart 1 include two indexes constructed by the ECB, one constructed by Bloomberg and
one by Goldman Sachs. For further information on the latter two indexes, see Hatzius, J., P. Hooper, F. S.
Mishkin, K. L. Schoenholtz and M. W. Watson (2010), "Financial Conditions Indexes: A Fresh Look after the
Financial Crisis", NBER Working Papers 16150.
3
The measures presented here consist of "narrow" FCIs, which focus on a limited but important set of financial
variables that are available at (intra-)day frequency. Some alternative, broader, measures also account for bank
lending or credit conditions, including for instance bank lending rates.
4
For similar arguments on the relevance of changes in the natural rate for Taylor rule prescriptions, see Yellen J.
(2017), "The Economic Outlook and the Conduct of Monetary Policy"; speech at the Stanford Institute for
Economic Policy Research, Stanford University, Stanford, California.
5
On history-dependence, see Woodford M. (2003). "Interest and Prices - Foundations of a Theory of Monetary
Policy". Princeton University Press; or Eggertsson G. B. and M. Woodford (2003). "The Zero Bound on Interest
Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The
Brookings Institution, vol. 34(1), pages 139-235.
6
See, for instance, Reifschneider, D. and J. C. Williams (2000). "Three Lessons for Monetary Policy in a Low
Inflation Era." Journal of Money, Credit and Banking 32(4), pp. 936-66; and Woodford, M. (2013). "Forward
Guidance by Inflation-Targeting Central Banks." Sveriges Riksbank Economic Review 3, pp. 81-120.