Olli Rehn: Transformation of central banking and monetary policy
in Europe
Lecture notes by Mr Olli Rehn, Governor of the Bank of Finland, lecture series "Current Trends
on European Politics", Helsinki University, 30 January 2020.
* * *
Accompanying slides of the speech.
Good Morning everyone. It is a great pleasure for me to give you a talk today as part of the lecture
th
series "Current Trends on European Politics". Recently, I noted the 20 anniversary of my
appointment as adjunct professor, or docent, at the University of Helsinki. I promised then to
restart my docent lectures - now, this is my third lecture this study year, so, perhaps
surprisingly, it seems I am practicing what I preach!
As a background for today's themes, let us first take a look at economic developments in the
euro area since 2008. The global financial crisis shook the world roughly a decade ago. In
Europe, the financial crisis soon escalated into the euro area sovereign debt crisis, which
delayed the recovery compared to other major economic areas. Finally, in 2013, the euro area
managed to get back onto the path of recovery and growth.
Slide 2. Economic activity in the euro area 2008-2022
More recently, euro area growth decelerated in 2018. The trade war, in particular, but also Brexit,
have considerately dampened growth in the euro area. The uncertainty surrounding the
economic outlook remains high, but growth is nevertheless expected to gradually normalise,
based largely on forecasts for a strengthening of the global economy.
Since the global financial crisis and the euro crisis, a lot has changed in the global economy, and
in economics and economic policy-making. In today's lecture, I will address how these
developments have transformed central banking and monetary policy in Europe. I shall focus on
three major changes that have taken place.
Slide 3. Outline of today's lecture
The first of these is an important philosophical change of direction at the ECB - a gradual
shift from its classical German roots, focusing solely on price stability, to becoming an active
Fed-type central bank with a more modern interpretation of its stability mandate.
Second, another significant change has been the stronger focus on the importance of financial
stability, which has now been brought to the centre of economic policymaking and central
banking.
The change relates to the environment in which central banks conduct their core business,
third
i.e. fulfil the price stability mandate. How should central banks react to the fundamental issues
raised e.g. by demographic developments, globalization and digitalization? To answer this
question, several central banks, including the ECB, have launched a
review of their monetary
policy strategy.
The ECB's transformation
I will start with the ECB's transformation. When the euro area debt crisis broke out in 2009-10, it
was clear that the Economic and Monetary Union (EMU) had become institutionally deficient. The
vulnerable Member States were exposed to financial market turbulence and outright market panic
as their liabilities - both their own indebtedness and contingent liabilities for banks' losses - grew
larger. At first, the ECB hesitated over whether it should take a more active role in stabilising the
euro area but, eventually, this became essential in order to calm the turbulence on the financial
markets and safeguard monetary policy transmission.
Since its inception in 1999, the ECB had conducted monetary policy mainly by steering
shortterm interest rates via so-called refinancing operations with banks. The global financial crisis and
serious problems in the functioning of the financial transmission forced several central banks,
including the ECB, to provide extraordinary support to their banking systems through various
means.
As a response to the European sovereign debt crisis, the ECB started to shift from focusing
solely on banks in monetary policy transmission to a broader-based approach. The fundamental
change in the ECB's monetary policy and its arsenal of measures came in autumn 2012, when
the Governing Council decided, in the wake of President Mario Draghi's "whatever it takes"
speech, to approve a programme of "direct monetary policy interventions" (Outright Monetary
1
Transactions, OMT). The programme came into effect in September 2012, but there has never
been a need to activate the purchases under it.
Furthermore, in 2014, the ECB introduced the negative interest rates policy. In early 2015, five
years after the US Fed, it launched an extensive securities purchase programme, also known as
quantitative easing. This helped to overcome the then-current threat of a deflationary spiral,
which would have eroded the economic recovery.
In hindsight, it seems that during 2010-2015, the ECB did, in fact, quietly leave its German roots
behind to become an American-style, more active central bank or, put plainly, went "from the
Bundesbank to the Fed". The change was pragmatic and gradual. Beneath the surface, however,
it turned out to be an important philosophical change of direction for European central banking.
What followed from the ECB's metamorphosis? It had two immediate effects. In the first place it
helped, together with the stabilisation of public finances and the creation of the European Stability
Mechanism (ESM), to restore financial stability and confidence in the banking system, which was
of decisive importance from the perspective of recovery and growth.
The second effect was that the ECB's decisions opened up new fiscal policy opportunities after
summer 2012, as they led to a decline in the yields on government bonds and helped eliminate
the immediate threat of default by euro area countries and their exclusion from access to market
funding. Although the ECB and euro area national central banks do not provide direct funding to
governments, government bond purchases on the secondary markets may be essential for the
functioning of the most important market segments in European capital markets.
The difficult experiences of the euro crisis taught us several key lessons. One essential
conclusion drawn by decision-makers at the time (myself included) was that returning the euro
area to a sustainable path of recovery required the determined restoration of financial stability.
Importance of financial stability
The financial system played a key role in the run-up to the euro area debt crisis. The seeds of the
problems were sown by the macroeconomic imbalances in the first decade of the new
millennium. The crisis strangled financial markets in 2008-2009 and again in 2011-2012, and led
to a steep rise in borrowing costs for the distressed euro economies.
High government bond yields had a damaging impact on growth in the distressed countries, as
they increased the funding costs of banks and resulted in a financial squeeze in the private
sector. In addition, a vicious circle was unleashed in the public finances: higher yields increased
the public sector's financial burden, amplifying the fears of default, as well as the anxiety that the
sovereigns could not guarantee the functioning of the banking sector, if it were to run into
solvency problems.
This sounds very much like the opposite of 'the financial accelerator', a concept developed by
professor Ben Bernanke, as a leading scholar of the Great Depression of the 1930s, long before
becoming Chair of the US Federal Reserve - we may call it The
"the financial decelerator".
gist is that 'recessions tend to gum up the flow of credit, which in turn makes the recession
worse'. In other words, during recessions, banks tend to lend more cautiously, as they are
burdened by losses, and at the same time borrowers tend to become less creditworthy, since
their finances deteriorate. Consequently, credit becomes constrained, which further dampens
consumer and investor demand, and thus amplifies the recession. Altogether, this vicious circle
2
puts economic activity into reverse gear.
Following the realisation that financial stability can only be neglected at our own peril,
macroprudential policy has essentially become the second key pillar of central banking today,
alongside monetary policy. As a complement to microprudential regulation and supervision-
focusing on individual institutions-macroprudential policy aims to ensure that the financial
system as a whole can withstand negative shocks.
While monetary policy is conducted by looking at the euro area as a whole, macroprudential
policy is largely at the discretion of the national authorities. It targets national, regional or local
conditions, especially in the housing market, and thus helps prevent booms and busts.
st
Monetary policy challenges in the 21 century
Before I go into the analytical challenges of monetary policy, let me first say a few words about
language and concepts.
I am well aware that the concept 'monetary policy' does not say much to ordinary citizens. Nor is
it always easy to perceive - which means
inflation an annual increase in the general level of
prices. For example, average annual inflation in the euro area in 2004-2015 was 1.8%, while
3
citizens' average estimate of inflation (mean perceived inflation rate) for the period was 9.5%.
Finland was an outlier (or "low-lier") among the euro area countries: we perceived that inflation
was 'only' 3.7%, while the second lowest figure was 6.2% and came from Portugal, and the third
lowest was 6.6% and was the perception of Germans.
However, the situation is not much different on the other side of the Atlantic. The Federal
Reserve has been fairly close to the country's inflation target of 2% in recent years. However, a
research paper published last September states the following: 'Strikingly, almost forty percent
answered that the Federal Reserve was targeting an inflation rate of 10% or more, which
suggests a pervasive lack of knowledge on the part of households about the objectives of the
4
Federal Reserve'.
By no means do I aim to discredit the views of ordinary citizens - on the contrary, I understand
well that different assessments stem from widely different everyday experiences. This does,
however, point out how challenging it is to conduct monetary policy and communicate about it.
The everyday, micro-level experiences of citizens do not always correspond with
macroeconomic statistical figures.
Slide 4. A common-sense definition of price stability
For this reason, too, it is worth repeating what price stability means. In other words, what
monetary policy aims to achieve. In the words of not one but two former chairmen of the Fed, I
consider the best uncomplicated definition for price stability to be 'an economic state in which
expected changes in the general price level do not effectively alter business or household
decisions' . This provides certainty and helps to focus on investment and consumption decisions
without having to needlessly worry about price changes. Most central banks have found a
symmetric inflation target of 2% to be the best way to guarantee price stability, prevent the risk of
deflation and - commonly speaking - oil the cogs and keep the wheels of the economy turning.
Let us next turn to the key analytical challenges in monetary policy.
1. The natural rate of interest is an important point of reference for monetary policy. It is
usually defined as the short-term real interest rate consistent with potential output and
inflation remaining constant at the targeted level. What does this imply? If the short-term
real interest rate is higher than the natural rate, monetary policy is contractionary. On the
other hand, when the short-term real interest rate is lower than the natural rate, monetary
policy is expansionary (or accommodative).
The task of the central banker is, however, complicated by the fact that the natural rate of interest
is not an observable variable, but must instead be inferred using a variety of theoretical methods.
Slide 5 shows estimates of the natural rate of interest for the euro area.
Slide 5. Estimates of the natural rate of interest
Interest rates in the euro area and other advanced economies are lower than before the global
financial crisis. It is likely that what is known as the 'long-term equilibrium real interest rate' has
also declined. This may be the result of an increase in the appetite for savings over investment
within the economy, which in turn is due to factors such as population ageing or a general
deceleration in productivity growth.
If the natural rate has indeed declined, monetary policy in the course of normalisation, i.e. when
interest rates are being raised, becomes tighter at an earlier stage than the past experience of
historical interest rates would suggest. Taking this logic further, the current low policy rates
would not imply as accommodative a stance of monetary policy as a central banker would
expect based solely on the level of policy rates.
In the longer run, a worrying consequence of a permanently lower natural rate of interest is that
the economy would hit the zero lower bound of interest rates more frequently than in the past,
and even following smaller negative (demand) shocks than in the past. The effectiveness of
conventional monetary policy would then be hampered, and its ability to fight recessions and
deflationary risks weakened.
2. A related issue is the persistent weakness of inflationary pressures in the euro area,
despite the significant recovery of the economy and the remarkable decline in
unemployment. How long will it take before the ongoing expansion results in a sustained
adjustment to a higher rate of inflation? How much longer will at least some monetary
stimulus be needed before the ECB's definition of price stability is satisfied?
These questions revolve around the Phillips curve, which describes the relationship between
inflation and economic slack. During and after the crisis, the behaviour of the Phillips curve
seems to have diverged from its past, as the rate of inflation has not picked up significantly,
despite higher economic growth and employment.
Slide 6. The Phillips curve is not stable - it has flattened
In other words, the Phillips curve may have flattened - a dilemma which has haunted economists
and central bankers throughout the post-crisis years. In the slide, different colours are used for
the Phillips curve to indicate different periods. We can see that the curve clearly points to a
negative correlation between underlying inflation and the rate of unemployment, which is in line
with economic theory. However, already for the years 2004-2008 the Phillips curve gets flatter.
Finally, when looking at the years 2010-2019, we discover that the Phillips curve is almost
horizontal, signalling that the above-mentioned correlation between inflation and unemployment
was no longer valid.
However, we must account for the potential non-linearity of the Phillips curve. As its inventor A.
W. Phillips himself said in 1958, "The relation between unemployment and the rate of change of
wage rates is likely to be highly non-linear". In the following slide, this is illustrated through the
relationship between wage inflation and the broad measure of unemployment (= U6).
Slide 7. The non-linear Phillips curve in the euro area, 2005-19
In the graph we note a non-linear empirical relationship between wage inflation and broad
unemployment. What is the implication? I would suggest a reading where wage inflation
accelerates significantly only once unemployment and economic slack have sufficiently been
reduced. This leaves us with the open question of pass-through from wage inflation to core
inflation. In any case, this way of interpreting the Phillips curve gives credence to the assumption
that euro area inflation is gradually converging to the ECB's price stability target.
All in all, there are widely differing views held in academia and central banking circles about the
validity of the Phillips curve - as an example, I will refer to a collection of quotes by top-class
economists from the ECB Forum on Central Banking in 2018: five economists, six opinions.
Slide 8. Quotes from the ECB Forum on Central Banking 2018, Sintra
Recall what Winston Churchill once quipped, "If you put two economists in a room, you get two
opinions, unless one of them is Lord Keynes, in which case you get three opinions".
In the above discussion, the Phillips curve relates the inflation rate to just one background factor
- a measure of slack, or untapped economic potential, in the domestic economy. In addition,
inflation is expected to react to other factors as well, not least to inflation expectations.
By 2015, it became evident that in the euro area were not anchored - or
inflation expectations
that the inflation aim of the Governing Council was perceived to be well below 2%. This is also
6
suggested in the Bank of Finland's own research. In light of modern economic theory, one
potential and worrying possibility is that the private sector's confidence in the central bank's ability
to stimulate the economy has weakened. This may be related to the decline in the natural rate of
interest.
Slide 9. Subdued inflation expectations in the euro area
According to the ECB's forecast, consumer price inflation will be 1.1% this year, after which it will
pick up to 1.4% in 2021 and 1.6% in 2022. According to the most recent statistical data, which
are from December 2019, official HICP inflation [Harmonised Index of Consumer Prices, slide 3]
is equally sluggish, at around 1.3%.
Slide 10. Euro area inflation clearly below the ECB's target
Underlying inflation, which is a more reliable measure of inflationary pressures, has been equally
subdued. Underlying - or core - inflation refers to an inflation rate that excludes the impact of
energy and food prices. It has been around 1% for over 6 years, which implies that cost
pressures within the euro area have been subdued. More recently, however, underlying inflation
has shown signs of a slight increase.
Review of Eurosystem monetary policy strategy
Since 2003 the euro area and the world economy have been undergoing profound structural
changes. These challenges are the main reason underlying the ECB Governing Council's
decision to launch a review of its monetary policy strategy. Since the introduction of the single
currency, the ECB has conducted a review of its strategy only once, in 2003.
Slide 11. ECB's strategy review in 2020
The forthcoming review will be based on thorough economic analysis and open minds, engaging
with all stakeholders. It will cover a quantitative formulation of price stability and the inflation aim,
the instruments of monetary policy, its impact and side-effects, as well as communication
practices. Other considerations, such as employment, financial stability and environmental
sustainability, will also be part of the review.
A key part of the ECB's strategic review is to listen to the views of civil society and stakeholders.
The ECB and national central banks will engage in dialogue with, for example, the European
Parliament and national parliaments, the academic community, researchers and analysts,
nongovernmental organisations, local communities and citizens in general. The strategic review
will be conducted with a tight timeline and the goal is to complete it before the end of 2020.
We should note that the purpose of the strategy review is not to change the ECB's price stability
mandate. This is enshrined in the Treaty on European Union. The purpose of the review is rather
to identify the impact of changes in the environment on the conduct of monetary policy. As
th
John Quincy Adams, the 6 President of the United States, once noted: 'I see no change in
policy, only in circumstances.'
Differing views on the definition of price stability impedes the conduct of monetary policy. In 2003,
the ECB decided to keep the definition of price stability unchanged, meaning that prices should
increase by less than 2%. The definition was supplemented with the inflation aim, 'close to but
below 2%', in order to achieve price stability.
Slide 12. A de facto ceiling of 2% for inflation dampens inflation expectations and lowers average
inflation in the long-term
From the perspective of inflation expectations, the ECB's definition is problematic since, in
principle, it allows inflation to temporarily slow close to zero. It can also be interpreted as setting
a 2% inflation cap. From this angle, the ECB's inflation target is clearly stricter than the targets of
its peers. The ECB's definition also leaves too much room for different interpretations. That is
why we now need to assess what kind of target is suitable for an environment of low natural
interest rates.
The US Federal Reserve System is also currently evaluating its monetary policy strategy. One
question that has been raised in the context of the Fed's exercise is whether it should consider
strategies that aim to reverse past misses of the Fed's 2 % symmetric inflation objective.
Monetary policy strategies that aim temporarily at higher inflation after a period of too-low inflation
are often called makeup strategies.
Former Federal Reserve Chair Ben Bernanke has suggested a strategy of temporary price-level
targeting. Under this strategy, following adverse shocks to the economy that force short-term
rates to zero, the central bank would commit in advance to refrain from raising rates at least until
any shortfalls of inflation from target during the zero lower bound period are fully offset. Meeting
this condition would typically involve some overshoot of the inflation target before rates would be
raised.
Makeup strategies can be seen as one of the most prominent responses to risks related to the
zero lower bound. The prospect of monetary policy stimulus and higher inflation in the future
promotes consumption and investment that could reduce the pain of being at the zero lower
bound. can also be interpreted as a makeup strategy, like the other
Average inflation targeting
backward looking definitions of inflation targets.
For makeup strategies to work, households and businesses should maintain their spending
levels during economic slowdowns. It is by no means guaranteed that such policies would work.
The proponents of makeup strategies usually argue that by including a makeup strategy
permanently into the central bank's toolkit, the credibility of makeup strategies could be
substantially increased.
Another viable option would be to converge towards flexible inflation targeting as
adopted by some central banks. Flexible inflation targeting means that the central bank aims to
keep inflation as stable and as close to the target as possible, while at the same time striving to
stabilise real economic activity close to full economic capacity.
In this policy model, the central bank's inflation target is, besides flexible, also symmetrical and
forward-looking. Symmetry, in this sense, means that the inflation aim is a point target that
guides the formation of inflation expectations, and from which deviations in both directions are
considered equally harmful and prompt symmetrical responses.
Recently, there has been support for the idea of setting a target range, rather than a point target.
The idea is that a range would reflect the uncertainty regarding the achievement of the inflation
target, thus leaving room to refrain from responding to price level changes that can be
considered temporary, such as tax changes or changes in energy prices. However, it is not clear
why setting a forward-looking inflation target with a view to the medium term would not yield the
same result.
The benefits and disadvantages of the range must also be analysed from the point of view of
anchoring inflation expectations. If having a range around the inflation target leads to a more
passive monetary policy, it is hardly likely to strengthen the central bank's ability to anchor
expectations.
In any case, I look at the issue of preferred price stability target with an open mind: if facts
change, or the analysis, I may change my mind.
Experiences in Japan
Recent studies looking at the experiences of Japan over the past decades demonstrate that
declining inflation expectations can become permanently stuck at low levels. This can lead the
economy into a prolonged period of low inflation, where monetary policy has little room for
manoeuvre. Consequently, a powerful monetary response is needed in situations where inflation
expectations have become depressed for a protracted period, so as to prevent a scenario where
inflation expectations become anchored at too low a level.
Slide 13. Japanification: Good or bad equilibrium for the euro area
Let us look at the relationship between inflation and interest rates and the economy at two
7
equilibriums: a good equilibrium, and a bad one.
The solid curve that is based on the data (red and blue dots) describes how monetary policy
reacts to inflation pressures. When the monetary policy [interest] rate reaches the zero lower
bound of interest rates and inflation turns into deflation, the economy is thought to be in a liquidity
trap (i.e. bad equilibrium, red circle). The equilibrium is bad because monetary policy is inefficient
when the interest rate is at the zero lower bound. The equilibrium is also bad because it is very
difficult to escape with the help of monetary policy. There is also another (good) equilibrium
where inflation is at the target and the interest rate is set accordingly.
In the graph, the red dots are Japanese data and the blue dots are euro area data. Japan is in
bad equilibrium, but the euro area has so far been able to stay out of it. One of the lessons from
the Japanese experience is that central banks should at all costs avoid letting inflation
expectations fall too low. To avoid this, the monetary policy reaction must be timely and strong -
and other economic policies, fiscal and structural, must support productivity and growth potential.
Before I conclude, I would like to briefly say a few words about the relationship between monetary
and fiscal policy. As I have explained today, the low interest rate environment and the effective
lower bound on nominal interest rates have been constraining monetary policy. More and more
attention has been devoted to fiscal policy and its capacity to help revitalise economies that are
suffering from subdued economic growth that is clearly below potential output.
It is clear that the role of fiscal policy is stronger in the current low-rate environment, which calls
for a better policy mix in the euro area than is the case today. Countries with fiscal space should
be prepared to use it to bolster investment and demand in a possible recession. Still,
highlyindebted countries should continue to build up fiscal buffers.
This underlines the importance of the correct policy mix between fiscal and monetary policy. By
no means is this in contradiction with central bank independence - that we will indeed defend!
But coordination that respects the independence of both players is also necessary in order for
fiscal and monetary policy to deliver the best possible effect in terms of both sustainable growth
and high employment, as well as stable inflation.
Slide 14. Walking the Highwire
I address these issues and the lessons of the euro crisis more in-depth in my book Walking the
Highwire - Rebalancing the European Economy in Crisis (Palgrave Macmillan, March 2020); the
Finnish translation was published in mid-October 2019 under the title Kuilun partaalta (Docendo).
Dear students,
In this lecture, I have tried to explain the central bank's efforts to overcome the economic crisis
and maintain price stability. Whether or not the central bank will succeed in its efforts will depend
largely on its understanding of the structural trends and economic cycles, and on the effects of
its own actions. In this pursuit, economics evidently plays a key role. But it alone is not enough.
So let me make two remarks to conclude.
Slide 15. Central banking and learning from economic history
Firstly, in one of his lectures, the eminent economist and consummate central banker Stanley
Fischer stated: 'I believe I have learned equally much from studying central bank history than
from central bank theory. Thus, I urge all those of you who are contemplating a career as a
central banker to read history books'.
In fact, deeper knowledge of economic and financial history would probably have inspired
economic policymakers to take credit cycles more seriously and learn from the experience of the
Great Collapse in 1929 and the Great Depression of the 1930s. What is more, as professor
Kevin O'Rourke has pointed out, with the help of economic history students and policymakers
are able to 'recognise that major discontinuities in economic performance and economic policy
8
regimes have occurred many times in the past, and may therefore occur again in the future'.
Finally, the ECB's monetary policy strategy assessment should be conducted first and foremost
on the basis of economic research ('in science we trust') and, secondly, with an open mind,
without setting out hard positions set in stone. And, while President Mauno Koivisto used to say
that economic policy is always wrong from some point of view, in this matter we should strive for
'domination-free discourse', in the spirit of the philosopher Jürgen Habermas, and let the best
argument indeed win.
Now I am ready to take your questions and hear your comments.
OMT refers to the Eurosystem's outright transactions in secondary sovereign bond markets that aim at
safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy. OMT is
considered once a Eurozone government asks for financial assistance from the ESM. Through OMT, the
Eurosystem can buy government-issued bonds that mature in 1 to 3 years, provided the bond-issuing country
agrees to certain corrective domestic economic measures - "conditionality". Outright Monetary Transactions are
not the same as quantitative easing (QE) operations, since, in the latter, the central banks buy bonds and, by
doing so, inject liquidity into the banking system, with the aim of stimulating economic activity.
2
Ben S. Bernanke, The Courage to Act. A Memoir of a Crisis and its Aftermath. W.W: Norton 2015, p. 35-36. See
also Ben S. Bernanke, Essays on the Great Depression, Princeton University Press 2000, p. 5-38; 70-160.
3
www.ecb.europa.eu/pub/pdf/scpops/ecb.op186.en.pdf.
4
Olivier Coibion - Yuriy Gorodnichenko - Michael Weber (2019): Monetary Policy Communications and their
Effects on Household Inflation Expectations. NBER Working Paper No. 25482.
www.nber.org/papers/w25482.pdf.
5
Alan Greenspan, FOMC meeting 2-3 July 1996: 'Price stability is the state in which expected changes in the
general price level do not effectively alter business or household decisions'.
Se e www.federalreserve.gov/monetarypolicy/files/FOMC19960703meeting.pdf. Paul Volcker, 28 December
1983: 'A workable definition of reasonable 'price stability' would seem to me a situation in which expectations of
generally rising (or falling) prices over a considerable period are not a pervasive influence on economic and
financial behavior. Stated more positively, 'stability' would imply that decision-making should be able to proceed
on the basis that 'real' and 'nominal' values are substantially the same over the planning horizon - and that
planning horizons should be suitably long.' See Volcker, Paul A., 1983. We Can Survive Prosperity: Remarks at
the Joint Meeting of the American Economic Association - American Finance Association, December 28, 1983.
6
Paloviita, Haavio, Jalasjoki, Kilponen (2019): What does close but below two percent mean? Assessing the
ECB reaction function with real-time data (forthcoming in IJCB).
7
In this graph, the dotted line describes a Fisher relation - a relationship between inflation and interest rates
when product markets are in equilibrium.
8
Kevin O'Rourke, Why economics needs economic history, 2013
voxeu.org/article/why-economics-needseconomic-history.