Peter Praet: Economic developments in the euro area
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the FT Debt Capital Markets Outlook Conference, London, 12 February 2015.
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I would like to thank John Hutchinson for his contribution to this speech.
Summary
Given the "gap" between inflation projections and our policy objective, we decided to launch
an expanded asset purchase programme. We had to act because the inflation outlook had
deteriorated, while our previous measures had not worked as effectively as we expected. In
this environment our decision was fully consistent with our reaction function, which we had
communicated last year, and it was only natural for markets to anticipate our move. Indeed
faced with an increasing risk of a too prolonged period of low inflation, we intensified our
stimulus to a degree necessary to bring inflation closer to 2%. We did it in line with our
mandate and price stability objective. And I have no doubt that the measures we took will
bring the intended effects.
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Ladies and gentlemen
Thank you very much to the Financial Times for inviting me to open this conference today.
As you know, the ECB Governing Council last month decided to launch an expanded asset
purchase programme to bring inflation back to levels closer to our aim of below but close to
2% over the medium term. What I would like to talk to you about this morning is the context
in which we took that decision and how we are calibrating our policy response.
The context for our recent decisions
A stylised way of thinking about why we introduced our recent measures is to use the
concept of the "inflation gap". This gap is the difference between our aim of an inflation rate
below but close to 2% over the medium-term and our projection for inflation over that same
horizon, based on our current monetary policy stance and the information on the state and
evolution of the economy that we have access to today. If the inflation gap widens, and the
monetary policy stance remains unchanged, it follows that there is a "missing stimulus" to
which we may need to respond.
At its meeting on 22 January, the Governing Council assessed that two factors had come
together which had led to a widening of this "inflation gap" and had hence rendered our
stimulus insufficient.
The first was the fact that the credit easing package we decided in June-October 2014 had
delivered less stimulus and thus less support to inflation than initially expected. And the
second was the fact that, in parallel and independent of the monetary policy stance, the
inflation outlook for the euro area had further deteriorated towards the end of the year. This
contributed to a further widening the inflation gap that our measures needed to close.
Let me explain each point in some more detail.
The initial impact of credit easing
For some time inflation dynamics in the euro area have been surprising on the downside,
and by June last year our inflation projections were suggesting that the risk of us not
achieving our mandate over the medium term was increasing. At that time we foresaw
annual HICP inflation at 0.7% in 2014, 1.1% in 2015 and 1.4% in 2016.
While our policy stance was undeniably very accommodative, our assessment was that it
was not being transmitted to credit conditions faced by the real economy in large parts of the
euro area, and that this in turn was hindering the economic recovery in the euro area as a
whole. What we observed was a feedback loop between weak macroeconomic
developments and weak demand for and supply of credit. The effect was downward pressure
on our medium-term inflation outlook.
Our response was the credit easing package we introduced between June and October last
year. This package was designed to achieve two types of transmission effects. The first was
a qualitative effect - to strengthen the pass-through per euro of liquidity injected to private
sector borrowing costs. The second was a quantitative effect - to generate volumes of
liquidity sufficient to activate portfolio rebalancing channels.
While the effects of such a package of course take time to materialise, our view was that by
the beginning of this year we should be in a position to make an initial assessment of
whether it was working as intended. And when the Governing Council evaluated the
effectiveness of the credit easing measures, our conclusion was that the pass-through
effects of the package were satisfactory, but the quantity side was below expectations.
In terms of pass-through, our measures now seem to be working their way through markets
and the economy. Bank lending rates to non-financial corporations (NFCs) have been
trending downwards since the third quarter of last year. By the end of last year, the
composite cost of borrowing indicators in Italy and Spain had declined by approximately
70 basis points and 50 basis points, respectively, when compared to the middle of the year.
This should be seen in a context where lending rates in these countries had not been very
responsive to monetary policy actions for at least three years.
These developments coincided with the first targeted longer-term refinancing operation
(TLTRO) and the announcement of the asset-backed securities purchase programme
(ABSPP) and covered bond purchase programme (CBPP3). I think it is therefore fair to say
that these measures have had a positive effect on compressing spreads.
In addition, on average net redemptions of loans to NFCs have moderated, with net lending
turning slightly positive in November. Results from the January 2015 Bank Lending Survey
have also been encouraging and indicate a further net easing of credit standards across all
loan categories in the final quarter of last year. And we are seeing that banks that
participated in last year's two TLTROs have been reducing loans by less than in the previous
year, and by less than non-participating banks, which have not altered their lending
behaviour to the same extent.
On the quantity side, the less favourable assessment is a reflection of the lower than
expected outturns for the TLTRO and a slower contribution from the outright purchases. This
has meant weaker portfolio rebalancing effects than we foresaw in the original calibration of
the package. For example, TLTRO borrowings enable banks to pay down market debt, thus
passing on cash to bank bond investors and encouraging them to rebalance their portfolios
and find alternative investment opportunities. A lower uptake in the TLTRO therefore
naturally weakens the strength of these effects.
The inference was thus clear: while our measures had been effective in certain ways, relative
to what we envisaged when we adopted our June-October package, they had not been
sufficient. They had not provided the degree of policy support to the inflation trajectory that
we saw as necessary to close the inflation gap.
The deteriorating inflation situation
In parallel, the inflation gap had widened as the inflation outlook had materially worsened
towards the end of last year. When we took the decision in January most indicators of
realised and expected inflation in the euro area stood at, or close to, their historical lows.
While the main driver of inflation developments in the months before was the sharp fall of
global oil prices, the conditions we faced made this shock different from a classic positive
supply shock, and we could not afford to "look through" the effects on inflation. Indeed,
several factors suggested that the present situation was more worrying than past episodes of
oil-induced disinflation, particularly the most recent case in 2009 following the collapse of
Lehman brothers.
First, the persistence of low inflation across a range of statistical metrics was higher than in
2009. This reflects the fact that, at that time, disinflation was very abrupt with inflation rates
expected to quickly revert back into positive territory. The current episode is characterised by
a prolonged downward inflation trend, and we expect inflation to remain in negative territory
until latter stages of this year.
Second, since last summer market measures of inflation expectations have become more
sensitive to realised inflation, even at maturities and at horizons that we would normally
expect to be more resilient. This is in stark contrast with 2009, where inflation expectations
hardly moved, even over the shorter end of the inflation forward curve.
Finally, measures of core inflation are less sticky today compared to 2009, which implies a
higher risk of second round effects materialising from low realised inflation and falling
inflation expectations. This in turn creates a higher likelihood that, absent policy action, low
inflation will become entrenched and will not bounce back when oil prices normalise.
The importance of fulfilling the mandate
In sum, what we saw was a real risk of not achieving our aim of an inflation rate of below but
close to 2% over the medium-term. And let me stress that there is no room for complacency
when inflation stays too low for too long. There are real costs to falling short of our objective.
Those costs are both institutional and economic.
First, in institutional terms, it is important to remember the very unique environment in which
we operate in the euro area. It involves multiple actors in multiple countries, and optimal
economic outcomes can only be achieved if each of those actors follows the rules in its
domain, thereby ensuring a consistent set of policies at the aggregate level. This is why, for
example, we constantly stress the importance of countries respecting the Stability and
Growth Pact rules.
However, if we were to miss our mandate as soon as it became difficult to achieve, how
would it affect the incentives of others in the euro area to fulfil their own mandates? Could we
still expect others to stick to their commitments - such as implementing structural reforms
and fiscal consolidation - in difficult times? And perhaps even more importantly, would our
credibility be preserved if we are given a narrow mandate but cannot deliver it?
Second, in economic terms, a too prolonged period of low inflation can negatively affect both
consumption and investment. Certainly, an oil price shock improves the terms of trade,
increases households' real disposable income and reduces the input costs for firms, thus
boosting aggregate demand. But if inflation expectations become de-anchored and second
round effects set in, then the sign of the effect can change. What is initially a positive supply
shock can morph into a negative demand shock.
This is first of all because at the zero lower bound falling inflation implies rising real interest
rates, causing households to postpone consumption and firms to delay investment, which
can then feedback into still lower inflation. In fact, when we took our decision expected real
rates had risen by almost half a percentage point in the previous few months alone.
These effects are then amplified in the presence of high levels of debt - as we see in the
euro area today. The reason is that if second round effects take hold, the debt burden in real
terms increases. The result is that a higher proportion of firms' and households' income has
to be diverted to debt service, eroding the positive term-of-trade gain arising from lower oil
prices. And this may have negative implications for aggregate demand due to the different
propensities to consume and invest of borrowers and lenders.
What we are concerned about here is of course not the extreme type of debt-deflation
scenario that Irving Fisher had in mind when studying the experience of the 1930s. We are
rather concerned about attrition: that the difficult process of recovering from the crisis and
working through the debt overhang in the euro area becomes even more complicated and
protracted.
Finally, it is important to remember that a too prolonged period of low inflation is not only a
cause of demand weakness, but also a symptom of it - as is evidenced in the decline in core
measures of inflation. The latter reflects underutilised resources, which if persistent can
produce hysteresis, scarring effects on the unemployed and underinvestment. This in turn
can permanently lower potential growth, which is also inimical to working through a debt
overhang.
Calibrating our response
In this context, with the risks of a too prolonged period of low inflation materialising, the
Governing Council saw a clear case for scaling up our monetary stimulus sufficient to
respond to it. In fact, nearly all Governing Council members agreed that in the situation we
faced, if there were still a margin for further interest rate cuts, we would have used it.
The question was however more complex: how to act when rates reach the lower bound in a
monetary union like the euro area. At this point, is moving from interest rates to asset
purchases as the main instrument of monetary policy simply a linear progression? Or does
the specific institutional makeup of the euro area mean that there are non-linearities when
the lower bound is reached, which in turn make large scale asset purchases of private and
sovereign paper an exceptional tool?
My own view is that when the central bank is in danger of missing its mandate, and it has a
tool at its disposal that is both legal and effective, it has to use it. Indeed, the Governing
Council is unanimous that the asset purchase programme is a monetary policy tool in a legal
sense. Yet at the same time, it is clear that the design of an asset purchase programme
including sovereign bonds has to reflect the specificities of the euro area institutional
framework with a single monetary policy and many fiscal authorities. And the Governing
Council decision reflects these considerations.
We have taken a significant monetary policy step, showing that we have the capacity and
determination to deliver our price stability mandate, and that we act in full independence. But
we have also acknowledged, through the loss sharing arrangement, the reality that the euro
area is not a fiscal union and it is for politicians, not central bankers, to decide if and when it
will become one.
Importantly, the expanded asset purchase programme was also in line with the
communication on our reaction function that we introduced last year to help observers
understand our strategy in an environment of heightened uncertainty. In a speech in April
2014 President Draghi laid out three contingencies that would warrant further policy action by
the ECB. And as each of those contingencies materialised, we responded as we indicated
we would.
In particular, we communicated explicitly that should we enter our "third contingency" - a
worsening of the medium-term outlook for inflation and/or a loosening in the anchoring of
inflation expectations - we would deploy a broad-based asset purchase programme. It is
therefore no surprise that market participants, seeing much the same economic and financial
data as we do, have largely anticipated this move.
It is important to keep this in mind as it helps clarify some misconceptions about what drives
the Governing Council's decisions. Long-term nominal interest rates have declined by around
100 bps since the middle of last year precisely because we specified our reaction function
and markets understood it. Therefore, the argument that asset purchases are unnecessary
because market interest rates have already come down, or that the ECB is "following"
markets, misses the direction of causality.
The transmission of asset purchases to the real economy
How does the asset purchase programme add extra monetary stimulus to the euro area
economy? It does so along five dimensions.
The first is the overall size of our interventions, which will be substantial. The second is the
pace, which will accelerate to €60 billion per month. The third is the composition of
purchases, which will include securities issued by euro area sovereigns and EU institutions.
The fourth is the maturity, which extends from 2 to 30 years. And the fifth dimension is the
horizon of our new measures, which will last until end-September 2016 or until we see a
sustained adjustment in the path of inflation consistent with our aim of achieving inflation
rates close to 2% over the medium term.
This combination of features will provide for full control over the scale and intensity of the
monetary stimulus. And while it will work through several transmission channels, we expect it
to be particularly powerful in terms of portfolio rebalancing effects. Put simply, the
displacement of investors' portfolios will be larger, faster and take place across more market
segments. This should also help reduce market segmentation arising from excess risk
aversion, improve confidence and lead to a generalised easing of financing conditions for
euro area firms and households.
While such effects have been extensively studied in other jurisdictions where large-scale
asset purchases were introduced, the way in which they work may differ in the euro area
compared with other regions given our specific financial structure - namely the prevalence of
bank-based over market-based intermediation. Indeed, I expect that an important
transmission channel for our new measures will be via banks.
Banks may tend to follow a pecking order strategy in their response to large-scale asset
purchases. In the first instance, those that sell their securities to the central bank, and thus
have an excess reserve position, may react by paying down market debt. This would create
scarcity in bond markets, thus inducing a portfolio rebalancing effect and leading in turn to a
compression of yields.
When this liability management reaches its limit, we would then expect that those more
favourable market funding conditions to translate into lower lending rates for borrowers in the
real economy - which is a key aim of our measures. This should be aided by the effect of
portfolio rebalancing on the returns on securities and its implication for banks' decisions to
grant loans.
Specifically, as expected returns on securities will be compressed, maintaining net interest
income will require banks to shift their portfolios away from securities and towards loans to
firms and households. Indeed, one reason that credit growth has been weak, especially in
peripheral countries, is that the risk adjusted returns for banks on loans have been very
subdued relative to returns on securities portfolios - especially domestic government bonds.
Moreover, as credit conditions further ease and the macroeconomic outlook improves, there
should be an endogenous effect on borrowing conditions. Insofar as banks expect lower
delinquencies thanks to improving macroeconomic conditions, they should require lower
credit risk premia from firms and households, implying lower lending rates. And insofar as
asset prices are boosted by our measures, collateral values will rise in tandem, implying
higher lending volumes.
Finally, we expect all these effects to be reinforced by the way we have calibrated our
programme, in particular the open-ended commitment to return inflation back close to 2%.
This strengthens the signal emanating from our decisions, which is visible in price
movements at the longer end of the yield curve. And it should also support the firm anchoring
of inflation expectations, which is crucial to avoid the self-reinforcing dynamics associated
with a too long period of low inflation that I mentioned above.
The pivotal role of governments
Still, it is clear that if our measures are to generate a faster and more sustained recovery
then governments also have to play their part. In particular, at both the micro and macro
levels, structural reforms are pivotal to encourage firms to capitalise on the easing of
financial conditions and undertake new investment projects.
At the micro level, any investment project will happen if the return on investment sufficiently
exceeds the cost of capital. Monetary policy can increase the wedge between the two on the
downside, by lowering the cost of capital. But structural reforms can increase the wedge on
the upside, by raising returns - for example by reducing costs arising from unnecessary red
tape.
At the macro level, monetary policy can influence investment through lowering the real
interest rate. But there also has to be a fundamental reason to invest, which comes down
chiefly to developments in labour participation and total factor productivity. Here again
structural reforms can complement monetary policy by, for instance, reactivating structurally
unemployed workers and improving allocative efficiency across firms, thus raising potential
growth.
Indeed, perhaps the biggest risk we face with our new measures is that they fall on barren
ground because governments are not doing enough to raise confidence in the future. If firms
are simultaneously revising down their growth expectations as we expand our monetary
policy, we will not see the impact we expect and which is required.
Yet the opposite story is also possible. If governments are determined in addressing their
structural challenges, all the conditions are there for growth to surprise on the upside. We are
already seeing, in countries like Spain, how improved financing conditions together with
targeted structural reforms can lead to stronger-than-expected growth outcomes. And if we
take advantage of the window of opportunity that exists today, that possibility is there for the
whole euro area.
Conclusion
Let me conclude.
The success of the euro area depends on every party doing its job, including the central
bank. For us that means being fully symmetric in how we interpret our mandate: acting as
decisively when the inflation outlook undershoots our aim as we would when it exceeds it.
This is our responsibility in the Treaty and our duty to the firms and households of the euro
area.
Remember that firms and households have entered contracts and entertain economic
relationships based on the expectation that we will meet our inflation objective. If we fail, then
we make their recovery from the crisis harder. And that loss of credibility would in turn make
it harder for us to deliver our mandate in the future.
That is why, faced with an increasing risk of a too prolonged period of low inflation, we
increased our stimulus to a degree necessary to bring inflation closer to 2%. And we will
continue to monitor the progress towards a sustained adjustment in the path of inflation.