Peter Praet: Current issues in monetary policy
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the Peterson Institute for International Economics, Washington DC, 9 December 2014.
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I would like to thank Tobias Blattner for his contribution to this speech.
Summary
The ECB has responded forcefully to counter growing risks of a too prolonged period of low
inflation. The current set of measures will enhance our monetary policy stance, incentivise
bank lending, overcome remaining impairments in our transmission mechanism and underpin
the firm anchoring of medium- to longer-term inflation expectations. Tentative evidence
suggests that our credit easing package is delivering some tangible first benefits. But we
need to remain vigilant as to whether the force of monetary stimulus already in the pipeline
remains sufficient to reach our objective. If needed, one option for the ECB to ease the
monetary policy stance further would be to extend its asset purchases towards other asset
classes. Purchases of different asset classes will affect private sector financing conditions to
varying degrees as they will activate different transmission channels and affect different
spread components.
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Ladies and Gentlemen,
Let me thank the organisers for inviting me here today.
Konrad Adenauer - Germany's first post-war Chancellor - once famously said, (and freely
translated): "Why should I care about remarks I made in the past?" He said so knowing that
the speed at which events unfold may - at times -outpace our comprehension of them at any
given moment. And when I went back to the remarks I gave here in the spring of last year,
my impression was that the pace of events over the past year or so was indeed dramatic.
In May last year I discussed two things.
I discussed the challenges monetary policy faces when banks engage in rapid leveraging
and deleveraging. I noted that "the central bank may have to be vigilant that the pace of
asset reduction by banks is commensurate with an evolution of income, activity, and
employment that does not create downside risks to price stability".
And I discussed the long-term strategy of the ECB. Here I highlighted two main attributes of
this strategy, namely that "it must be sufficiently flexible to adjust its policy conduct to the
specific challenges at hand. And it must be sufficiently binding to anchor expectations and
build central bank credibility with market participants and the general public".
When reading through my notes, I asked myself: did we indeed have a steady eye on the
state of the banking sector? And have we applied the two principles of our strategy - that it is
flexible and binding - in what turned out to be a very challenging year or so for monetary
policy in the euro area?
I think the answer to these questions is a qualified yes.
A flexible policy response
Let me start from the spring of this year.
Our diagnosis at that time was that borrowing rates were becoming too unreactive to policy
changes. We saw that our policy impulses - a combined cut of 50bps in our key policy rate
over the preceding year - were no longer being transmitted to private borrowing costs in the
way they used to.
As a result - and despite our very accommodative stance - bank lending rates remained at
elevated levels in large parts of the euro area. This meant that weak credit dynamics were
increasingly becoming a source of downside pressures regarding our medium-term inflation
outlook.
In other words, a dysfunctional bank lending channel was in full display: excessively
restrictive borrowing conditions were suppressing demand in the countries where they were
applied, and indirectly - through intra-euro area trade linkages - were contributing to
economic weakness in the rest of the euro area.
So, we had a very close eye on the banking sector as you can see. How did we respond to
our diagnosis?
In the face of these risks, we did precisely what any central bank would have done: we acted
to restore transmission and bring down the average borrowing costs paid by households and
firms to levels more consistent with the intended stance of our policy.
This was the philosophy underlying our credit easing package that we adopted between June
and October this year.
The transmission mechanism we wanted to activate - the bank lending channel - was quite
simple and, I would add, orthodox in its underlying logic.
Our targeted long-term refinancing operations (TLTROs) provide significant term funding
relief for banks: a very low fixed rate over a period of up to four years. They are designed to
maximise the chances that banks pass the funding relief on to their borrowers. Banks will
have to repay loans in advance if they fail to meet the agreed lending benchmark. And the
more they lend beyond the benchmark, the more they are allowed to borrow. This positive
incentive is amplified by the use of a multiplier.
This shows clearly that we put incentives first, employing them to counteract the existing
impairments in the bank lending channel.
The ABS purchase programme (ABSPP), which we first announced in June and which
became operational in November, will help further lubricate the transmission process. It can
activate the same scarcity channel that was found to be a critical ingredient in the success of
the Fed's Large Scale Asset Purchase Programme.
This channel works as follows: ABS purchases push down the market spreads paid on senior
tranches, currently the main focus of our purchases. They do so by subtracting volumes from
potential private investors in such tranches, and thus encourage banks to relieve the
resulting scarcity by originating more ABS. Ultimately, they can only do this by creating more
loans.
The result is again an increase in loan supply. And as the supply of loans shifts to the right
along a given demand for credit, lending rates adjust downward to create the necessary
demand.
In September we added an additional leg to our June package: purchases of euro area
covered bonds (CBPP3), again with a view to making credit more abundant and less
expensive. Covered bonds share some of the characteristics of the ABS: notably, they are
loan-backed securities where the same scarcity channel can be put to work.
Importantly, the CBPP3 has also strengthened the quantitative dimension of our policy. By
increasing the pool of purchasable assets - and by communicating our intention that our
combined measures will help bring the ECB's balance sheet back to levels it had in early
2012 - we are providing guidance on the overall scale of our interventions; a scale
considered necessary to deliver the intended support to inflation and the recovery of the euro
area economy.
And in scaling up the volume of our measures, we have also broadened the scope of
transmission. The TLTROs and the ABSPP primarily work through what is called a direct
price and pass-through effect. That is, both measures are designed to ensure an unimpeded
transmission of our actions to the ultimate borrowing costs of the private sector.
Purchases in the covered bond market will have a similar effect, but because of the size and
liquidity of the market, other transmission channels may become more important in relative
terms. In particular, our covered bond purchases will also activate two prime transmission
channels of large-scale asset purchases: the portfolio rebalancing and signalling channels,
which are more dependent on the size of the monetary stimulus.
So, I think it is fair to say that our response so far has been flexible. The diagnosis that led to
our credit easing package identified a dysfunctional bank lending channel as a prime threat
to achieving our ultimate objective of price stability. Our measures were tailor-made to that
objective and offer a powerful response to address the root cause of the impaired bank
lending, and thus to facilitate new credit flows to the economy.
Is it working? Tentative evidence suggests yes: our credit easing package is indeed
delivering some tangible first benefits.
Broad measures of nominal financial conditions have eased and spreads on senior ABS and
covered bonds have fallen. Consistent with our expectations, price adjustments have been
particularly pronounced in those segments where we intervened directly. The case of the
ABS market stands out: spreads fell by an impressive 70bps since May although our
purchases only started a few weeks ago. By way of comparison: the Fed's QE-1
announcements, which involved combined purchases of nearly $2tn of MBS, Treasuries and
GSEs, are estimated to have lowered 30-year MBS yields by some 100bps.
At the same time, the broad-based nature of the easing across markets suggests that the
signalling effect - operating through a flattening of the OIS curve - has also been a powerful
element of our response.
Lending rates have fallen too. Since May the composite indicator of the nominal cost of bank
borrowing for euro area NFCs fell by 40bps to 2.6% in October. In Italy this indicator fell by
nearly 60bps. In other words, the premium Italian firms pay for bank borrowing relative to the
average euro area firm has fallen in recent months - a sign that the transmission of our
policy is gaining traction.
Lending volumes seem to be responding too. Evidence is growing that a turning point in loan
dynamics might have been reached. As a result, the downward pressure on the output gap
stemming from impaired credit supply is levelling off. At the same time, banks also report an
increase in loan demand, which means that our measures come at the right time: banks
would not borrow under TLTRO unless demand for loans strengthens.
A binding policy response
But flexibility aside, have we also adhered to the other element of our strategy I mentioned
last year: have our measures been binding enough? Here we need to be more cautious in
our assessment.
The fact is that - despite our broad-based measures and the associated fall in private
borrowing costs - inflation has not stopped trending down. In November inflation in the euro
area fell back to a cyclical low of 0.3%. When we last met here in May 2013 it was still at
1.4%. The sharp fall in oil prices since the summer - down by 30% in euro terms since early
June - explains a significant portion of this fall.
But measures of underlying inflation - stripping out volatile items such as energy and food -
have also continued trending down. Falling core inflation points to weakness in broad
aggregate demand - consistent with the loss of economic momentum we observed in recent
months. And our latest staff projections foresee a material downgrade of the macroeconomic
outlook.
These developments have also affected inflation expectations. Short-term inflation
expectations have almost moved in tandem with the fall in headline inflation. But more
recently - basically since the summer - we have also observed a fall in medium- to long-term
inflation expectations. In principle, these should not be too reactive to short-term commodity
price gyrations.
Does this mean our actions have not been binding enough?
Not necessarily. First, notwithstanding their recent decline, most market- and survey-based
measures of medium-term inflation expectations remain in close vicinity to our aim to keep
inflation close to, but below 2%. Second, the fall in market-based measures was not limited
to the euro area. Break-even rates and medium-term inflation swaps also fell in other
jurisdictions, such as in the US.
This of course does not mean that we can ignore these developments. Well-anchored
inflation expectations are indispensable for medium-term price stability. They provide a
nominal anchor for the economy. And even more so in the current environment: given the
potency of the current oil price shock, the risk is that inflation may temporarily fall into
negative territory in coming months.
Normally, any central bank would prefer to look through a positive supply shock. After all,
lower oil prices boost real incomes and may lead to higher output in the future. But we may
not have that luxury at present. The reason is that shocks can change: in certain
circumstances supply shocks can morph into demand shocks via second-round effects. In
these conditions monetary policy needs to react to what initially appeared to be a supply
shock, so as to prevent a destabilisation of inflation expectations.
Remember: this is the binding element of our strategy.
In light of this, the Governing Council last week reiterated that should the monetary stimulus
fall short of our intention to move our balance sheet towards the dimension it had at the
beginning of 2012, or should it become necessary to further address risks of a too prolonged
a period of low inflation, it remains unanimous in its commitment to using additional
unconventional instruments within its mandate. This would imply altering early next year the
size, pace and composition of our measures. ECB staff and the relevant Eurosystem
committees have therefore stepped up the technical preparations for further measures with a
view to implementing them in a timely manner, if needed. Indeed, all of our monetary policy
measures are geared towards underpinning the firm anchoring of medium to long-term
inflation expectations, in line with our aim of achieving inflation rates below, but close to, 2%,
and contribute to a return of inflation rates towards that level.
Extending the policy response
Extending our outright asset purchases towards other asset classes could be one option if
we were to judge that the economy was in need of further stimulus. It is important though to
constantly keep in mind our intention, our purpose in adopting further measures. Asset
purchases are not an end in themselves. They are not a target of monetary policy. They are
an instrument of policy.
To see this, let us conduct a thought experiment: faced with the circumstances we have now,
how would we have reacted in normal times - that is, with positive policy rates and no
impairments in transmission?
In my view we would have lowered rates further by now. This reaction would have been
consistent with and guided by the wealth of evidence gathered over time on the transmission
of changes in our key interest rates to borrowing rates and to economic activity and inflation.
So, when we say our measures intend to bring our balance sheet back to levels seen in early
2012, what we are really saying is that - given the current composition of the unconventional
monetary policies that we have put in place - this is the amount needed to bring inflation in
the medium term back to levels closer to 2%.
And in a bank-based economy such as the euro area, pinning down this amount rests
crucially on the effectiveness of our measures in reducing the borrowing costs of households
and firms.
It follows from this that an important criterion for the choice of additional measures - if
needed - should be their degree of influence over broad financing conditions in the private
economy, scaled up to an amount of easing judged sufficient to achieve our price stability
mandate.
This might give rise to a trade-off: some assets might ex ante be more effective than others
in reducing private borrowing costs, but might be in short supply. Others might be in
abundant supply, but less effective a priori and plagued by institutional complications.
Understanding the effectiveness - and hence the transmission - of purchases is therefore
key to calibrating both the size and composition of our response in case we need to act
further.
Purchases of different asset classes will affect private sector financing conditions to varying
degrees as they will activate different transmission channels and affect different spread
components.
For example, purchases of bonds issued by euro area non-financial corporations (NFCs)
would probably have some direct pass-through effect to the financing costs of those firms
which have the standing and ability to tap credit markets directly. And they could indirectly -
through a sort of "trickling down" effect - make credit more abundant and less expensive for
smaller firms by increasing the scope for banks to redirect credit provision from larger to
smaller enterprises. Also, very low market-based funding costs might incentivise
mediumsized firms to replace more expensive bank lending by issuing bonds.
But compared to other asset classes, the market for NFC bonds is relatively thin and quite
heterogeneous across the euro area. This could imply that potential portfolio rebalancing and
signalling effects would be contained. Furthermore, the large issuers which are active in this
market are in all likelihood on average not financially constrained, which may limit the
propagation of easier funding conditions to their decisions to expand capacity.
The transmission would work differently if we were to decide to buy bonds issued by euro
area sovereigns.
This would be the only market where size would generally not be an issue. Interventions in
this market would therefore likely entail a stronger signal that the ECB - consistent with our
forward guidance - is committed to maintain an accommodative stance for an extended
period of time. This signal should not only compress the risk-free curve further, it should also
spill-over to inflation expectations, thereby helping to lower the real expected rate of interest.
We would also expect broad portfolio effects to materialise with sellers of government bonds
willing to reduce their excess holdings of cash by bidding up the price - and hence lowering
the yield - of alternative financial instruments other than those purchased by the central
bank.
For banks, broader portfolio effects might entail a shift out of government bonds - or other
fixed-income instruments - and into loan creation. This essentially works through banks'
opportunity cost of lending. Our analysis shows that sovereign spreads in some Member
States are still preventing lending rates from falling further. Remember that the existence of
large spreads in the sovereign bond market was probably one of the main reasons why our
3-year LTROs had a limited effect in terms of stimulating credit supply by banks.
Although these spreads have narrowed sharply, there remain considerable differences in real
- that is, inflation adjusted - yields across countries. Therefore, if purchases of government
bonds were to reduce banks' opportunity cost of lending by lowering the return of other
alternative investments, this might create the incentives for banks to extend credit to the
private sector, in particular if banks regain confidence and start to reappraise the
macroeconomic outlook as a result of central bank action. In addition, our presence as a
buyer in the ABS and covered bond markets eases potential balance sheet capacity and
liquidity concerns that go along with an increase in credit supply.
A precondition for these channels to unleash their full effects is a healthy banking system.
The higher banks' capital ratios, the lower their bad loan exposure and the more transparent
their balance sheets, the larger are the chances that the quantitative impulses of the central
bank will get transmitted to the wider economy.
In this sense, the completion of the Comprehensive Assessment and the start of the SSM will
provide important support to current and potential future efforts to revitalise sluggish lending
in the euro area. In particular, increased clarity and transparency about banks' balance
sheets, together with a better capitalised banking sector, will create a more supportive
lending environment.
Of course, effectiveness is not the only criterion to assess the potential for new measures. In
the euro area, the deliberation also needs to build on and factor in the institutional
specificities of the euro area, including the boundaries set by the Treaty, notably with respect
to the monetary financing prohibition and the no bail-out clause.
That is, we cannot simply import the experience from other central banks. We have to
carefully design measures that are tailored to the institutional set-up of the euro area. Unlike
other central banks, we are not dealing with a single fiscal authority but with a multitude of
national fiscal authorities.
Conclusion
Let me conclude.
Since June the ECB has responded forcefully to counter growing risks of a too prolonged
period of low inflation.
Taken together, our measures will have a sizeable impact on our balance sheet, which is
intended to move towards the dimensions it had at the beginning of 2012. In the coming
months, our measures will further ease the monetary policy stance more broadly, support our
forward guidance on the key ECB interest rates and reinforce the fact that there are
significant and increasing differences in the monetary policy cycle between major advanced
economies.
But the latest euro area macroeconomic projections indicate lower inflation, accompanied by
weaker real GDP growth and subdued monetary dynamics. In this context, early next year
the Governing Council will reassess the monetary stimulus achieved, the expansion of the
balance sheet and the outlook for price developments. We will also evaluate the broader
impact of recent oil price developments on medium-term inflation trends in the euro area.
Should it become necessary to further address risks of too prolonged a period of low
inflation, the Governing Council remains unanimous in its commitment to using additional
unconventional instruments within its mandate. This would imply altering early next year the
size, pace and composition of our measures.
Thank you.