Vítor Constâncio: Monetary policy challenges in the euro area
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the Annual
Conference of the Marshall Society on "The power of policy: solving problems and shaping
the future", Cambridge, 31 January 2015.
This is the full text of a speech delivered in abridged form in Cambridge on 31 January.
* * *
Summary
The monetary policy experience of the past seven years is reviewed. In pursuit of its
objectives, the ECB has been very flexible in adjusting and expanding its toolkit.
In a first phase, from 2008 to 2013, monetary policy measures aimed at easing financial
constraints arising from malfunctioning money and funding markets. Non-standard monetary
policy was conducted in a context of well-anchored inflation expectations. It was not aimed
at, but unavoidably resulted in, the expansion of the ECB's balance sheet.
The second phase, since 2013, is characterised by a more active use of the ECB's balance
sheet, as inflation started to fall significantly below 2%, accompanied by declines in various
measures of long-term inflation expectations. Non-standard measures, introduced as from
July 2013, included a policy of forward guidance, asset purchase programmes of private
debt, a programme to provide targeted long-term funding to banks and an enlargement of the
asset purchase programme to include sovereign bonds.
A number of concerns have been voiced regarding the adoption of a large scale asset
purchase programme (APP) in the euro area. It is argued that these concerns are unfounded
since: the transmission channels of the APP go well beyond the direct effect on the price and
yield of the purchased assets; government fiscal discipline should not be achieved at the
expense of central bank independence; central banks have instruments to absorb the effects
of an expanded monetary base should inflation become a risk in the future; and finally,
exuberance in specific asset markets should be addressed with macro-prudential policy
tools, at national level, since price stability relevant for monetary policy refers to the market of
goods and services, not to asset markets at large.
At the moment, the euro area is suffering mostly from weak aggregate demand. Supply-side
policies are necessary to increase the medium-term growth potential. Monetary policy,
aiming at price stability by stimulating demand and supporting investment, should reduce
employment and output gaps, thereby positively affecting medium-term growth.
***
Ladies and Gentlemen,
Let me start by thanking the organisers for this invitation to participate in the Annual
Conference of the Marshall Society. It is a pleasure to be here and support the Marshall
Society's quest to further young economists' interest in economics.
The subject of this year's conference is ambitiously on the power of policy to solve problems
and shape the future.
In modern times, monetary policy is usually considered the most powerful of the macro
policies to stabilise the economy. It was not always assessed like that and it is important to
be aware of its limitations. For instance, it is sometimes said that the world avoided the worst
in 2008, only because central banks made bold use of their tools, cutting rates and providing
abundant liquidity. The truth is that without the significant use of fiscal policy in 2008 and
2009 stimulating our economies and supporting the banking sector, the meltdown of the
financial system could not have been avoided. At their meeting in Toronto in 2010, the G20
decided to reverse the policy and embarked in fiscal consolidation, to different degrees,
leaving monetary policy to deal with macroeconomic stabilisation. In this context, it is easier
to explain by fiscal policy short-term effects, the double dip suffered by the euro area
economy after 2011, than by the behaviour of monetary policy.
The tasks for monetary policy became particularly challenging in the euro area, in view of the
imbalances built prior to the crisis by private debt expansion and the subsequent sovereign
debt crisis of 2010-2012.1 The resulting financial fragmentation made the proper
transmission of monetary policy more difficult.
The first part of my remarks today will be dedicated to briefly review the experience of the
past seven years in order to illustrate two broad features of the Governing Council's
response to the evolving phases of the crisis. The first feature is naturally that all ECB
actions have always been guided by the compliance with its mandate, which is to maintain
price stability as a primary objective as I will clarify below.
The second feature is that, in the pursuit of its objectives, the ECB has been very flexible in
adjusting and expanding its toolkit. Flexibility has been an important principle to ensure that
economic and financial shocks would be met by the most efficient response at any point in
time. Without going into the details of the individual instruments that we have operated, I will
identify two broad phases in our response to the crisis. The two phases are characterised by
different uses of our balance sheet as an instrument of monetary policy.
This will lead me to comment on the implications of our approach for the current cyclical
phase. The main message that I would like to convey is the following: even if the traditional
instruments of monetary policy, short-term interest rates, are constrained below zero, central
banks have other tools, including large scale asset purchases, to ensure price stability over
the medium-term. The ECB has never hesitated to use these tools, in accordance with its
mandate. The monetary policy measures announced between June 2014 and last week are
a testimony of our resolve and our independence.
The ECB's goal and strategy
Let me start by recalling the exact contours of the ECB mandate. Monetary policy in the euro
area has a strictly lexicographic mandate. Price stability is its primary objective according to
Art. 127 of the Treaty. It is only without prejudice to the objective of price stability that the
ECB should support the general economic policies in the Union, including the stabilisation of
output and unemployment, as well as financial stability.
The review of the ECB strategy in May 2003 clarified that price stability in the euro area is to
be understood as a year-on-year increase in the harmonised index of consumer prices
(HICP) below but close to 2%. Another fundamental aspect of the ECB's monetary policy is
that it aims to pursue price stability over the medium-term and not every quarter or every
year. This emphasis on the medium-run recognises the fact that monetary policy cannot
stabilise prices at short-horizons and that short-term fluctuations are inevitable, especially if
they result from supply shocks. Hence, the ECB is not an "inflation nutter", to use the
expression of Mervyn King, ready to implement extreme changes in its policy instrument to
try to prevent any blip in inflation. As long as they are temporary, short-term fluctuations in
inflation do not pose a threat to price stability, because they do not affect inflation
expectations in the medium-term, and, therefore, key economic decisions such as wage
formation or real interest rates.
This medium-term approach to the inflation target, as demonstrated by Lars Svensson2, an
eminent supporter of a "flexible inflation targeting" framework, is equivalent to an optimal
policy rule resulting from optimising an objective function containing simultaneously the
deviation of inflation from the target and the output gap. This means that a medium-term
strategy for the inflation target does not ignore what is happening with the output stabilisation
or the slack in the economy. More trivially, it is clear that there are many situations, like the
present one, where aiming at the inflation target by influencing aggregate demand is fully
aligned with the goal of stabilising the output gap.
These two features of monetary policy in the euro area - an overriding emphasis on price
stability accompanied by a publicly announced, numerical definition of the inflation
objective - are also key characteristics of inflation targeting strategies. According to an
influential definition, the inflation targeting approach "is characterised, as the name suggests,
by the announcement of official target ranges for the inflation rate at one or more horizons,
and by explicit acknowledgment that low and stable inflation is the overriding goal of
monetary policy."3
In practice however, the debate on the monetary policy strategy of the ECB has mostly
focused on its differences from the theoretical notion of "flexible inflation targeting".4
Specifically, the ECB itself has emphasised its reliance on two pillars: a broadly-based
assessment of the outlook for future price developments and a prominent role for monetary
analysis. However, since the review of the ECB strategy in May 2003, the high-level
similarities between our two-pillar strategy and inflation targeting are even more striking. In
particular, the Governing Council clarified the definition of price stability. As a safeguard
against the risks of deflation, it stressed that inflation should remain "below, but close to 2%",
not just "below 2%", over the medium-term. The Governing Council also emphasised that
monetary analysis mainly serves as a means of cross-checking, from a medium to long-term
perspective, the short to medium-term indications coming from economic analysis. It
therefore decided to discontinue the previous practice of conducting a review of the
reference value for a broad monetary aggregate on an annual basis. This decision was also
consistent with the ongoing deepening and broadening of the analysis, under both pillars, to
go beyond any individual indicator.
The publication of the ECB staff macroeconomic projections for the euro area, available
since June 2004, goes in the same direction of underscoring the similarities between our
two-pillar strategy and the notion of inflation forecast targeting.
Hence, at a broad level, the ECB monetary policy strategy is not radically different from
inflation targeting. Differences emerge when we look at a finer level. For example, although
the review of our strategy led to a reduced emphasis on the role of the broad monetary
aggregate M3, our broader monetary pillar continues playing a role. The evolution of credit
and the growth rate of various monetary aggregates are for instance relevant inputs in our
assessment of the risks to price stability in the medium to long-term.
All in all, the signposts guiding ECB actions have remained unchanged since the launch of
the Monetary Union in 1999. They include the primary goal of price stability, as defined
numerically in 1998 and clarified in 2003, and a comprehensive strategy which encompasses
information from both economic and monetary analyses.
The precise instruments employed by the ECB to pursue its goals have, however, starkly
changed after the financial crisis. We have devised many new tools, which we have defined
as "non-standard measures". In describing such measures, I think it is useful to identify two
broad phases, which I describe in turn.5
The ECB as a lender of last resort
The first phase covers the period from 2008 to 2013. Following the ECB's decision to
immediately and sharply reduce interest rates in the aftermath of the Lehman bankruptcy,
this phase was marked by the decision to conduct many different types of operations to
refinance banks.
The immediate objective of these operations was to ease unwarranted liquidity constraints
for financial institutions, arising from the malfunctioning of the money market and bank
funding markets in general. Our measures ensured that solvent but illiquid institutions could
continue to have access to our primary liquidity provision. This can be characterised as
performing a role of lender of last resort, a traditional function of central banks since the
19th century.6 In the face of impairments in private funding markets, the ECB stepped in and
provided unlimited liquidity to all banks subject to adequate collateral.
In late 2011 the banking sector faced a new severe liquidity squeeze and two large
extraordinary liquidity provision operations were conducted, amounting to €1 trillion, for a
three year maturity but payable after one year.
While the immediate objective of this lender of last resort activity was to ease funding
constraints and prevent sound institutions that were experiencing temporary liquidity
shortages from collapsing, its ultimate objective was to pre-empt risks to price stability over
the medium-term, and therefore fully in line with our mandate. If left unaddressed, funding
tensions would have led to impairments in the euro area monetary policy transmission
mechanism, with adverse consequences on the provision of credit, the real economy, and
ultimately inflation. As history has taught us, a liquidity crisis could have triggered a wave of
bankruptcy, leading to a Great Depression scenario. Thanks to our non-standard measures,
this scenario did not materialise. The fall in inflation rates at the peak of the Great recession
was short-lived and inflation expectations remained solidly anchored at levels that were fully
consistent with our definition of price stability.
A side-effect of the non-standard measures implemented in this phase was to produce an
increase in the size of the ECB balance sheet. Starting with the collapse of Lehman Brothers,
the increase in financial institutions' demand for ECB liquidity led to a progressive, and
sizeable, increase in bank reserves. Between 2007 and mid-2012, the ECB balance sheet
more than doubled in size. This increase was not the direct objective of our non-standard
measures, but only the endogenous result of liquidity needs from the banking sector. Indeed,
after a fast growth, the balance sheet started to slowly decline from mid-2012 onward, as the
funding situation in the banking sector improved.
Some commentators have interpreted the size of the balance sheet as a direct signal of
future high-inflation risks. Similarly, the more recent reduction in the size of the balance sheet
was interpreted by some as a cause of recent deflationary pressures.7
These views are wrong and based on traditional technical monetarism, are ultimately rooted
in the existence of a long-run link between money and prices and on a predictable relation
between the monetary base (or simply, the size of their balance sheet) and the broader
monetary aggregates. When applied to the euro area experience, it must however be
qualified in two important ways.
The first qualification is theoretical, but related to a property of the operational framework of
the ECB. The unlimited provision of liquidity to banks was accompanied by a policy of
remuneration of bank reserves at an interest rate linked to our main policy rate - the rate on
our Main Refinancing Operations (MRO). This policy has been in place ever since the start of
the Monetary Union and it implies that banks can smoothly adjust their desired amount of
central bank liquidity without bearing a large cost, when excess liquidity is deposited at the
central bank in the form of excess reserves. In the case of a monetary framework where
reserves are fully remunerated, changes in the amount of bank reserves become completely
endogenous. Increases in the quantity of reserves can be the result of temporary liquidity
shocks and, as a result, never be followed by corresponding increases in prices.8
The main point though is that those predictions are not supported by the empirical evidence.
The large increase in the euro area monetary base until mid-2012 has never led to an
acceleration of inflation. In the same vein, the decrease of our balance sheet since mid-2012
is not responsible for the trend of low inflation that started in 2013. Even over the longer
sample ranging from the beginning of 2007 to the end of 2014, this interpretation of the
balance sheet suggests that today we should be concerned about strong, upward risks to
inflation, because the monetary base in the euro area increased by about 120% over this
period. The problem today in the euro area, however, is not too high, but rather too low
inflation. Let me recall that this disconnection between the monetary base and inflation has
also been observed in other countries. It is especially striking in the United States, where the
monetary base increased by more than 300% between 2007 and 20149 and there were no
signs of strong inflationary pressure.
There is no theory of inflation, even in technical monetarism, based only on the central bank
monetary base increase without a corresponding development in broad monetary aggregates
and this never happened. During the Great Recession, when the ECB balance sheet started
its expansion, M3 growth fell dramatically to negative levels. Since 2010, M3 growth has
remained very low, at average levels below 2%.
To sum up, the first phase of non-standard monetary policy was conducted in a context of
well-anchored inflation expectations. Our non-standard measures over this period were
aimed at addressing specific market impairments, to pre-empt risks to price stability over the
medium-term. These measures produced implications on the size of the ECB balance sheet
only as a by-product, as the size of the balance sheet was passively determined by the
demand for liquidity emanating from the banking sector.
The more recent phase: more active steering of the ECB balance sheet
The second phase of our non-standard measures started in 2013 and corresponds to the
period during which inflation started to fall significantly below 2%. HICP inflation hovered
below 1% in the second half of 2013 and kept drifting down over the entire 2014, reaching a
slightly negative level, -0.2%, last December. These developments were accompanied by a
significant decline in various measures of long-term inflation expectations.
This situation is different from the one faced by the Governing Council in previous years. One
way to characterise the difference is in terms of the nature of the shocks that are likely to
have determined economic outcomes. Specifically, the Great Recession and the years
before 2013 were characterised by a large increase in financial spreads and relatively stable
inflation. This suggests that financial disruptions were the root cause of real economic
developments. Recent academic results for the United States have confirmed the realism of
this hypothesis from a quantitative perspective.10 In contrast, current downward pressures on
both output and inflation are not accompanied by an increase in financial market spreads.
For instance, the spread between the three-month EURIBOR and three-month euro
overnight interest swap (OIS), identified as a key indicator of money market tensions, is
currently hovering around levels last seen during the pre-crisis period. Right now, with more
favourable yields and spreads the situation suggests that current developments of low
inflation, high unemployment and significant economic slack, are more likely to be driven by
a negative aggregate demand shock. There is a general lack of demand in the euro area and
at the present pace the negative output gap would last until 2019, with a corresponding high
unemployment that is fostering socio-political tensions.
Maintaining price stability in the face of insufficient aggregate demand and downward
inflationary pressures requires a more expansionary monetary policy stance that, by reducing
the economic slack, will contribute to improve price stability in the medium term.
In response to these developments, the Governing Council of the ECB introduced, in July
2013, a policy of forward guidance, indicating its intention to keep interest rates at prevailing
or lower levels "for an extended period of time".11 In June 2014, the Governing Council also
introduced two purchase programmes, for asset backed securities (ABS) and covered bonds,
and a programme to provide longer-term funding to banks for new loans, which we refer to
as targeted long-term refinancing operations (TLTRO).
The negative developments after the preparation (in November) of the December staff
projections and the relatively weak use by the banks of the TLTRO, led the ECB to enlarge
the Asset Purchase Programme (APP) by including sovereigns bonds and by deciding to
calibrate a monthly amount of €60 billion purchases of the three types of assets. This amount
of purchases is "intended to be carried out until end-September 2016 and will in any case be
conducted until we see a sustained adjustment in the path of inflation which is consistent with
our aim of achieving inflation rates below, but close to, 2% over the medium-term".12
The switch to a more active steering of the ECB balance sheet is the distinguishing feature of
the new phase of our non-standard measures. It is important to underline the nature of this
new phase. We are not thinking of increasing our monetary base, expecting that through a
working and stable multiplier the monetary aggregates will increase correspondingly thus
achieving an upward movement in inflation, by whatever ways the traditional quantitative
approach conceived. We decided on a Large Scale Asset Purchase (LSAP) mostly to be
able to use several new channels of transmission of an expansionary monetary policy. The
increase of the monetary base and the total balance sheet is a consequence of this new type
of monetary stimulus.
By purchasing this type of long-maturity assets, we intervene directly on medium-term rates,
we extract duration from the market, we provide liquidity directly to non-bank entities, we
open space in banks' balance sheets for increasing credit. Also, by reducing persistent
market spreads, in ABSs for instance, we encourage banks to increase their supply. As new
money origination can only be achieved through the creation of more loans, this measure
has the potential to increase the supply of credit and reduce the price at which it is granted.
Another important channel through which we expect asset purchases to work in the euro
area is the broad portfolio balance channel. If different assets are imperfect substitutes,
interventions by the central bank that affect the supply of various assets available to private
investors could influence the prices of many other assets, including investment grade bonds,
equities, real estate or foreign assets with consequences for the exchange rate.13 Higher
valuation would also facilitate the process of balance sheet repair that is ongoing in the euro
area, and more generally contribute to support credit growth. We see that the various effects
also impact the credit channel.
Finally, asset purchases would operate through a signalling effect, i.e. by affecting
expectations of future inflation and the future likely path of the key ECB rates. In the United
States, there is for instance evidence suggesting that quantitative easing contributed to
increase inflation expectations, and therefore that asset purchases by the Fed reduced real
interest rates.14 Lower real rates would stimulate aggregate consumption and investment,
and ultimately contribute to a faster return of the euro area inflation rate to levels consistent
with our definition of price stability.
The adoption of a Large Scale Asset Purchase (LSAP) programme
The ECB is responsible for price stability which is always effectively controlled by monetary
policy on a medium-term basis. Having reached the zero lower bound of our policy rates, we
had the duty to try all legal instruments to fulfil our mandate. In the present case, it implied
exploring new channels of transmission of monetary policy that have worked in other
countries like the U.K. and the U.S.
We were, of course, aware of several objections and concerns that have been used against
adopting a LSAP Programme. One concern at this point in time relates to the already very
low level of government bond yields. There is certainly limited scope for further yield
reductions through a government bonds' purchase programme. Nevertheless, the
transmission channels of the programme go well beyond the direct effect on the price and
yield of the purchased assets as I just explained. Besides the points already mentioned,
government bond purchases at this point in time would firm markets' expectations that the
monetary policy stance of the ECB will remain expansionary for an extended period, even if
interest rates started rising in other monetary areas. While current expectations are already
consistent with persistently low levels of key ECB interest rates, government bond purchases
should produce further reductions in yields by dampening their volatility in reaction to news
and therefore their risk premia.
We should also not forget that the recent reduction in government bond yields has been the
result of increasingly widespread market expectations of a forthcoming ECB programme to
purchase such bonds. The announcement of such a programme would therefore be effective
by merely validating those expectations and thus preserving the low yield levels.
A second concern is that purchases of government bonds may have adverse unintended
consequences. Specifically, they could reduce governments' incentives to undertake the
necessary structural reforms or fiscal adjustments in countries where they are needed.
All policies imply trade-offs and an independent central bank, responsible for price stability in
an acute situation, cannot be condemned to inaction by arguments related to the amount of
pressure that it may exerte or not on governments regarding other policies for which they are
responsible. There are other instruments to achieve appropriate fiscal discipline that are in
the hands of the EU Commission and Member States.
Concerns regarding possible future inflation resulting from the increase in the monetary base
have been less prominent this time. These traditional views have been disproved by the facts
since 2007 and, in any case, the central banks have instruments to absorb the effects of the
monetary base, if and when inflation would threaten to become a risk again.
Then, there is the argument that in the present environment of low interest rates, a LSAP
Programme can reinforce the trend of search for yield and lead to instability in asset markets.
The question is that monetary policy cannot tackle two objectives at the same time. Our
primary mandate as stated in the EU Treaty is price stability in the market of goods and
services and not the market for assets. What this implies is that central banks must be given
a second set of instruments of a regulatory nature under the umbrella of what is now called
macro-prudential policy. When the business cycle diverges from the financial cycle, as is the
case now, bold and efficient macro-prudential policies are essential, even if their more
intrusive nature raises doctrinal objections in certain quarters. Advanced economies have no
alternative in the present environment of secular stagnation, because otherwise the
reluctance to tame excessive leverage of finance can lead to future crisis.
Finally, there is the misguided argument that the euro area problem is almost exclusively a
supply side question. The supply side policies are indeed absolutely essential to increase
long-term potential growth by fostering total factor productivity, especially now when working
age population is already declining. However, they take time to produce effects and there is a
short-term horizon of two to three years where the question is mostly a situation of lack of
aggregate demand and Europe needs to increase growth now in order to avoid vicious
circles related with the so-called debt-trap.
Short-term stimulus to demand also helps the long-term and the supply side. In reality, only
in our textbooks is there a pedagogical but artificial separation between the short-term and
the long-term or between the supply and the demand side. The nature of mathematical
economic models enhances this pseudo-difference as they feed the confusion between
logical time (long-term in the models only means a logical interval until the final equilibrium)
and the chronological time that we face in policy-making.
In the historical chronological time, the long-term is no more than a sequence of short-terms.
In the case addressed, the main links between the short and the long-term are investment
and hysteresis in the capital and labour markets. As we all know, investment has collapsed
since 2007 and in the euro area is still almost 20% below what it was then. This has
decreased the long-term potential growth rate as the capital became less efficient (hysteresis
effect) and has not grown sufficiently. Hysteresis in the labour market means that
unemployed human capital loses quality, is discouraged and abandons the labour supply so
that short-term prolonged high unemployment affects the long-term.
In the present situation, monetary policy, by aiming at inflation, stimulates aggregate demand
and, by doing so, positively affects medium-term growth, if indeed investment increases and
the output and employment gaps are reduced.
To conclude, I should refer to an important dimension of policy decision-making which is the
cost of inaction. At the moment, default risk in the sovereign debt market is, in almost all
countries, a result of the prolonged recession, rather than the outcome of current
irresponsible fiscal actions. From this perspective, a sovereign bond purchase programme
would foster growth and thus be instrumental in making any further consolidation of
government finances possible.
We have been encouraged by the initial reaction to our decisions: the portfolio rebalancing
was reflected in increases in the price of equities and bonds and on the exchange rate. A
word of caution is however necessary about the measurement of the effectiveness of our
decision. Indeed, it is not correct to look only for what happens to financial and real variables
after the date of our decision. Firstly, because the measures have been partially anticipated
by the markets, so that the effects started even before our decision was taken; secondly
because it is necessary to compare with the counterfactual of what could have happened if
the measures had not been adopted. As we are not in the domain of natural experimental
science, the counterfactual has to be model-based with all the caveats of such endeavour.
Concerning inflation itself, in the short-term, the impact of oil price declines is likely to
prevail. Nevertheless, monetary policy can indeed control inflation on its own, on a
mediumterm basis, provided the proper instruments are used with persistence and determination.
This is a basic tenet of theory that ultimately is the argument that justifies the independence
of central banks. Other policies can indeed help and should help but in the end, monetary
policy alone can do it. Inflation is the main remit of central banks and a responsibility that no
independent central bank can disregard. That is why, we have repeated several times in the
past few months that "Should it become necessary to further address risks of too prolonged a
period of low inflation, the Governing Council is unanimous in its commitment to using
additional unconventional instruments within its mandate".
Thank you for your attention.