Speech
Normalising monetary policy in non-normal
times
Speech by Fabio Panetta, Member of the Executive Board of the
ECB, at a policy lecture hosted by the SAFE Policy Center at Goethe
University and the Centre for Economic Policy Research (CEPR)
Frankfurt am Main, 25 May 2022
Following the acute phase of the pandemic, central banks in most advanced economies have started
to withdraw stimulus as the recovery has progressed and inflationary pressures have emerged. In the
jargon of central bankers, this process is often described as bringing about a "normalisation" of
monetary policy.
We are not, however, in normal times.
Unlike some other advanced economies, the euro area is not facing a situation of excess domestic
demand. As ECB President Christine Lagarde recently noted, "consumption and investment remain
1 ]
below their pre-crisis levels, and even further below their pre-crisis trends".[
Instead, the euro area is confronted with a war on its doorstep that comes on top of a series of
negative supply shocks generated abroad. These shocks - above all the increase in energy prices -
are creating sizeable and persistent upward pressures on near-term inflation. But by hitting real
incomes, confidence and ultimately domestic demand, these shocks could derail the post-pandemic
recovery.
In other words, the very shocks that have led to a surge in inflation are also depressing output. As a
result, the inflation path is starting from a much higher point but the medium-term inflation outlook is
characterised by high uncertainty.
In this situation, policy normalisation needs to be clearly defined, and how it is carried out needs to be
carefully judged and calibrated. In my remarks today, I will outline what it means to normalise
monetary policy, what implications this normalisation has for our policy instruments, and how far it
should go.
For now, given the exceptional level of uncertainty we face, we should normalise our monetary policy
gradually, in line with the progressive adjustment that has inspired our action in recent months.
What is normalisation?
Let me begin by defining what normalisation is, and what it is not.
Normalisation occurs when the central bank adjusts its policy parameters as medium-term inflation
2
approaches its price stability objective[ ], so as to achieve this objective durably.
In other words, normalisation describes a situation in which monetary policy is shifting from a stance
that aims to raise the inflation path - for example, by making the policy stance more expansionary - to
one that aims to cement the inflation path at the target.
There are three important distinctions we need to make about normalisation.
Normal does not mean neutral
First, normalisation is not the same thing as a neutral policy stance, which is when monetary policy is
neither accommodative nor contractionary for the economy. A neutral stance allows the central bank to
stabilise inflation around its target when output is at potential and when there are no transitory shocks
disrupting the inflation path.
But if we have a situation where there are shocks depressing the economic outlook, uncertainty is high
and output is still below its potential level, cementing the inflation path at 2% would require a gradual
withdrawal of accommodation, so that the stimulus is reduced over time but does not suddenly
disappear.
Normal does not mean theoretical
Second, the normalisation process should not be assessed against unobservable reference points,
3 ]
such as the natural (or neutral) rate of interest[ and some optimal or "normal" size and composition of
the central bank's balance sheet in the long run. These concepts are only vague guideposts at the
best of times, and they are particularly fraught with uncertainty in the current environment.
Before the pandemic, the real natural rate of interest for the euro area was estimated to range from
4 ]
just over 0% to less than -2%, depending on the model used.[ In fact, proxies of real rates are
already at the higher end of that range - for instance, the one-year forward real rate nine years ahead
[ 5 ]
recently increased significantly, reaching 0%.
But the natural rate of interest is particularly hard to estimate at the moment, not least because the
pandemic has scrambled all the typical models used to calculate it. All we can say with confidence is
that the natural rate of interest has declined significantly compared with the period before the global
financial crisis and that estimates are imprecise and widely dispersed. As such, they cannot serve as
an actual guide for policy.
The picture is further clouded when it comes to the "normal" size and composition of the central bank's
balance sheet. It is unlikely that the prevailing size and composition prior to the global financial crisis
are still valid benchmarks - we can surmise that the optimal balance sheet is different in size and
6
composition today. But there has so far been little empirical work in this area[ ], so it cannot serve as
an actual guide for policy either.
This uncertainty means we should think about normalisation in terms of changes in the degree of
accommodation we are providing based on the medium-term inflation outlook, rather than the distance
of our policy tools from their unobservable theoretical levels.
So, if we were to see shocks that would lead to the medium-term inflation path being revised upwards,
we would change our policy stance to reduce accommodation more rapidly - and vice versa - so as to
keep inflation on target over the medium term.
Normal does not mean conventional
Third, normalisation does not imply adjusting unconventional instruments more rapidly than
conventional ones. In the review of the ECB's monetary policy strategy that we completed last year,
we were clear that both types of instrument are essential and permanent components of our toolkit.
What matters is finding the combination of tools to deliver the necessary policy stance in the most
effective and proportionate way.
In the ECB's case, we currently have three main levers that we can, in principle, use to adjust policy.
The first is interest rates, which have a greater influence on the short and medium-term segments of
the risk-free yield curve.
The second is asset purchases, which have a greater influence on the longer end of the yield curve
and risk premia.
The third is the provision of liquidity through our targeted longer-term refinancing operations
(TLTROs). TLTROs influence the transmission of benchmark yields to bank lending conditions, as well
as overall liquidity conditions in the financial markets. This, in turn, helps to control rates at the short
7 ]
end of the money market and affects risk premia.[
Various combinations of tools could be used to achieve the desired policy stance.
For instance, if we bring net purchases to an end but continue to reinvest the stock of assets
purchased, our balance sheet will keep supporting the economy through what is known as the "stock
8
effect"[ ], but it will no longer provide additional accommodation. In fact, for technical reasons, the
9 ]
degree of accommodation it provides is likely to decrease over the coming years.[
So the appropriate stance could in principle involve maintaining a constant stock of assets purchased
under our asset purchase programme (APP) and pandemic emergency purchase programme (PEPP).
At the same time, we would be using interest rates to adjust the degree of policy accommodation - so
long as this combination of tools remains consistent with inflation stabilising at 2% over the medium
term.
Overall, this way of defining normalisation is consistent with our inflation-targeting framework. It is not
about targeting unobservable natural settings for our instruments, or about preferring some tools over
others. Rather, it is about using an efficient mix of instruments to achieve the policy stance that
effectively cements inflation at 2% over the medium term.
Calibrating policy normalisation
Even if the goal of normalisation is relatively straightforward, calibrating this policy normalisation
process in the euro area today is extraordinarily complex.
In my view, there are two principles we need to apply to orient the normalisation process correctly. The
first is gradualism, and the second is robustness.
These principles can, in turn, help us to define the pace of normalisation and the mix of instruments.
Gradualism
As William Brainard proposed in his seminal work, gradualism is necessary when the transmission of
10 ]
policy changes to the economy is uncertain.[ In such conditions, the optimal policy involves moving
cautiously and observing how the economy responds to a gradual adjustment.
Gradualism is clearly appropriate in the euro area today, for several reasons.
First, the nature and strength of recent shocks is generating extreme uncertainty about the outlook for
economic activity in the period ahead. The range of plausible outcomes is wide.
The economy has faced a series of negative global supply shocks in the form of surging energy and
commodity prices, compounded by supply bottlenecks.
The Russian invasion of Ukraine and "zero Covid" policies in China are now prolonging and amplifying
these shocks, which are all contributing to very high imported inflation. The higher cost of imports, in
turn, is eating into domestic demand and pulling production away from full capacity, reinforcing the
war's negative impact on confidence.
It is hard to gauge how far-reaching and persistent the implications of the hit to euro area consumer
and business confidence will be. The weakening in consumption registered this year suggests that the
rise in near-term inflation expectations is not prompting consumers to bring purchases forward. Rather,
11
as recent research findings illustrate[ ], it is leading households to be more pessimistic about their
12 ]
real income and to reduce their consumption.[ In other words, the depressing effect on consumption
from higher inflation is working through the expected - and not just the realised - hit to real income.
We may also be underestimating the full impact on global growth of the simultaneous tightening of
financing conditions across advanced economies, coupled with the slowdown in China. A recent
13 ]
survey suggests that global growth optimism has collapsed to record lows.[
The second reason why gradualism is appropriate is that, given the unprecedented nature of the
shocks we are facing and the lack of reliable benchmarks for our policy stance, we can only truly
gauge the effects of the withdrawal of accommodation by getting feedback from the economy. This
means not only monitoring soft leading indicators - like inflation projections and expectations or
confidence indicators - but also assessing hard data on financing conditions and economic activity. As
a result, we will have to move step by step, reassessing and adjusting our policy as necessary.
In an environment where leverage in the economy is high, small rate increases might have larger
effects. We are already seeing some evidence of this in the United States, where some highly
leveraged segments of asset markets - such as the technology sector - are responding strongly and
non-linearly to policy adjustment. During the pandemic, demand has largely been concentrated in
sectors that are sensitive to interest rates, such as durable goods and construction. This could also
mean that rate increases will have a sizeable effect on demand.
The considerable uncertainty surrounding how monetary tightening will be transmitted through broader
financing conditions and across the euro area is another reason why we should take small steps.
Typically, at cyclical turning points financial markets become more volatile and banks' lending policies
14 ]
are more difficult to forecast.[ In the euro area, this latter effect is reinforced by the phasing-out of
the TLTROs.
Of course, a gradual approach is not appropriate in all circumstances. For example, when faced with
15 ]
deflationary shocks that risk rooting interest rates at the lower bound, it pays to act more decisively.[
The same is true when inflation expectations are threatening to become de-anchored or if we see
16 ]
incipient signs that a wage-price spiral may start.[
The current short-term inflationary pressure may spill over to inflation expectations, leading to more
protracted inflationary pressures. These risks have to be carefully considered when we are deciding
on both the pace and path of the withdrawal of accommodation.
If we were to see clear signs of a de-anchoring of medium-term inflation expectations, we would
accelerate the pace of withdrawal, and we could go further and adopt a restrictive stance if necessary.
17
For now, we do not see this "ugly inflation" scenario materialising[ ], but the risks need to be
monitored. Currently, premia-adjusted market-based measures of inflation expectations are consistent
with inflation meeting our 2% target at the end of 2024, and being slightly below 2% from 2025
18 ]
onwards.[
Robustness
Turning to the second principle, we need to choose the mix of instruments that is most robust to the
19 ]
wide range of plausible scenarios we are facing.[
This calls for us to avoid normalising our monetary policy using all instruments at once, in order to
minimise uncertainty and reduce the risk of financial stability being negatively affected.
The natural way forward would be to start raising interest rates while keeping the stock of assets
purchased under the APP and PEPP constant. This seems the most appropriate approach for a
number of reasons.
First, the size of our balance sheet is already expected to significantly shrink and its composition will
change as the TLTROs are wound down, ultimately leading to a reduction of around €2.2 trillion in
excess liquidity.
Second, we do not need to risk unsettling financial markets via a passive runoff or active sales of
bonds we hold on our balance sheet, given that we could proceed with the necessary withdrawal of
accommodation in other ways. Starting to reduce the stock of assets purchased under the APP and
PEPP would likely exacerbate the impact of rate changes, both along the yield curve and on risk
premia, especially if liquidity is declining.
Third, although we have plenty of experience of how asset purchases and policy rates can reinforce
each other as part of an easing strategy, we have no experience of the reverse scenario in the euro
area. And the experience of other major central banks, limited as it is, is unlikely to be transferable to
the euro area given the unique nature of our economic, financial and institutional set-up.
In this context, we will be much more able to anticipate the consequences of gradually adjusting rates
while keeping our balance sheet constant.
Using policy rates to withdraw accommodation thus allows us to better calibrate the adjustment that is
consistent with 2% inflation over the medium term. This reduces the risk of an overcorrection that
would durably depress the economy. And, at the same time, it allows us to move faster if the risk of
second-round effects starts to materialise.
Tightening policy through rate changes would also be simpler for us to communicate and easier for the
general public to understand, reinforcing confidence and the anchoring of inflation expectations at our
target.
So, once net asset purchases have come to an end and the stock is being reinvested, I see rate policy
as being clearly superior to balance sheet policy as the main tool to deliver these various goals.
This is the position of the ECB. We currently intend to end net asset purchases in the third quarter.
However, even after net asset purchases come to an end and policy rates start to rise, we still intend
to continue reinvesting in full the principal payments from maturing securities.
Policy implications
So what does this imply for the ECB's normalisation process today?
Subject to incoming data - we are and should remain data-driven - both the economic outlook and the
principles I have outlined justify ending net asset purchases and then gradually exiting negative rates.
This would allow us to continue to normalise policy by removing the part of our monetary
accommodation that is no longer needed today. In particular, negative rates may imply distortions
which were only necessary and proportionate when inflation was threatening to be too low over the
medium term, relative to our target.The first adjustment is already under way. The ECB has already
made two major announcements on asset purchases, first in December last year, and then again in
March, when we signalled our expectation that net asset purchases would be concluded in the third
quarter of this year. At the same time, the stock effects associated with our reinvestment policy will
ensure that accommodation is withdrawn gradually. This will avoid creating financial stability risks in an
already very volatile and uncertain environment.
The second adjustment - the adjustment to our deposit facility rate - would allow the recent rise in
medium-term inflation expectations to be reflected in our monetary policy. It would be consistent with a
progressive removal of accommodation, still allowing us to steer output back towards potential but
confirming the direction of normalisation that has already led to an increase in rate expectations.
By the time we consider the next steps, we will have more information on which to base our decisions.
In particular, we will have a better sense of two key developments.
First, the sensitivity of the economy to the significant adjustment in financing conditions that is already
under way, so we can gauge whether the pace at which we are withdrawing accommodation is
appropriate.
We have already seen a material increase in nominal yields and real rates in recent months. In fact, an
adjustment is already working its way through the economy. And according to our latest bank lending
20 ]
survey, banks expect to tighten credit conditions markedly in the coming quarters.[
The second key development will be how resilient the domestic economy is to the combined impact of
the war, lower real incomes and a darkening global outlook.
21 ]
So far, we are seeing a clear weakening of soft leading indicators.[ Signs of economic stress are
22 ]
emerging in the hard data[ - signs which may become more visible in the coming months.
Against this background, pre-committing to further steps - just like ruling them out - seems
unnecessary and unwise.
The uncertainty we are facing makes it harder to accurately forecast economic developments beyond
short time horizons. Given these circumstances, speculating about monetary policy measures over an
extended period of time would be a futile exercise at this stage, as further evidence is needed in the
period ahead.
Finally, a critical element in determining the normalisation process will be how rate increases are
transmitted across the euro area. In this respect, ensuring monetary policy is transmitted smoothly and
evenly and delivering the adequate degree of policy normalisation are two sides of the same coin. And
this is not a new concept for the ECB.
During the recovery from the global financial crisis, the ECB applied a "separation principle" to its
various policy tools, whereby measures that prevented financial fragmentation could be deployed
regardless of the level of interest rates. The logic was that delivering the appropriate policy stance
should not come at the cost of disrupting the transmission of the stance through the financial sector.
I believe a similar principle should apply today. In particular, we should be ready to intervene as
needed to neutralise any non-linear market responses that may arise from raising rates, and to
mitigate the impact of an asymmetric tightening of financing conditions within the euro area. In other
words, we should avoid the risk of a "normalisation tantrum".
An anti-fragmentation tool of this nature would be even more beneficial if we were to see incipient
signs of a de-anchoring of inflation expectations or risks of a wage-price spiral, which would dictate
that rates should rise more rapidly. We should thus ensure that we are in a position to credibly
announce the availability and readiness of such an anti-fragmentation tool.
In other words, addressing fragmentation risks is central to the normal conduct of monetary policy in
the euro area.
At the same time, the successful implementation of the national investment and reform plans under
the Next Generation EU programme remain critical to support macroeconomic resilience, thereby also
addressing fragilities that increase fragmentation risks. And joint European investments to reduce
energy dependence would help cushion the effects of the idiosyncratic shocks that may result from the
23 ]
war.[
Conclusion
Let me conclude.
The ECB is currently dealing with the economic effects of an unprecedented sequence of shocks
generated abroad. Like other major central banks, we are faced with the task of normalising monetary
policy at a point in time that is anything but normal.
In this difficult situation we will guarantee medium-term price stability, just like we protected the euro
area economy from deflation during the pandemic.
Normalisation does not mean removing stimulus outright. Rather, it is a process of gradually reducing
that stimulus in a way that firmly anchors the inflation path at 2% over the medium term. This process
has already got under way in the euro area.
Getting normalisation right is no easy task, as the euro area economy must contend with an outlook
that is marked by exceptional uncertainty. This means we should normalise our monetary policy
gradually and choose a mix of instruments that is robust to the wide range of plausible scenarios we
could face.
These tried-and-tested principles have proved instrumental for central banks in the past. We should
remain true to them today.
1.
Lagarde C. (2022), " Monetary policy normalisation in the euro area ", The ECB Blog, 23 May.
2.
In the ECB's case, the price stability objective corresponds to 2% inflation over the medium term.
3.
The natural rate of interest is the real interest rate level that contemporaneously brings output into line
with its potential and stabilises inflation at the central bank's target in the absence of transitory shocks
or nominal rigidities. See Brand, C., Bielecki, M. and Penalver, A. (eds.) (2018), " The natural rate of
interest: estimates, drivers, and challenges to monetary policy ", Occasional Paper Series, No 217,
ECB, December.
4.
As detailed in Chart 16 in Panetta, F. (2022), " Small steps in a dark room: guiding policy on the path
out of the pandemic ", speech at an online seminar organised by the Robert Schuman Centre for
Advanced Studies and Florence School of Banking and Finance at the European University Institute,
28 February. See Brand, C., Bielecki, M. and Penalver, A. (eds.) (2018), op. cit.; and Lane, P.R.
(2022), " The monetary policy strategy of the ECB: the playbook for monetary policy decisions ", speech
at the Hertie School, Berlin, 2 March.
5.
The "one-year forward real rate nine years ahead" is the market's judgement of the one-year real
interest rate prevailing nine years from now.
6.
The literature on the optimal size of the central bank balance sheet is limited. Charles Goodhart
provided an initial discussion of this notion in Goodhart, C. (2017), " A Central Bank's optimal balance
sheet size? ", Discussion papers, No 12272, Centre for Economic Policy Research. As regards the
ECB's balance sheet, there is no established view about the desirable ("optimal") size and composition
in the long run. It is clear, however, that any attempt to determine an optimal size and composition
would need to take stock of the evidence from the global financial crisis, the sovereign debt crisis and
the COVID-19 crisis. Moreover, balance sheet policies have been recognised as a key instrument in
the ECB's monetary policy toolbox, as reflected in the ECB's monetary policy strategy statement . See
also Altavilla, C., Lemke, W., Linzert, T., Tapking, J. and von Landesberger, J. (2021), " Assessing the
efficacy, efficiency and potential side effects of the ECB's monetary policy instruments since 2014 ",
Occasional Paper Series, No 278, ECB, September.
7.
Barbiero, F., Boucinha, M. and Burlon, L. (2021), " TLTRO III and bank lending conditions ", Economic
Bulletin, Issue 6, ECB.
8.
Stock effects of asset purchases relate to the persistent changes in bond prices due to the ensuing
variations in the (risk-adjusted) stock of bonds that private investors are expected to hold. Notably,
asset purchases lead to a compression in term premia via the extraction of duration risk from the
market (see Altavilla, C. et al., op. cit.). Because markets are forward-looking, stock effects generally
arise upon a policy announcement (or in anticipation of the announcement) and are influenced by the
expected future evolution of central banks' asset holdings. Empirical evidence suggests that stock
effects account for the bulk of the impact of asset purchases and are likely to last longer (although
assessing their duration is extremely difficult). Conversely, within the academic literature, "flow effects"
refer to those effects that emerge through the actual implementation of the purchases and generally
reflect improvements in liquidity conditions and market functioning during periods of high financial
stress. The evidence suggests that flow effects are typically contained and short-lived. It is notable,
however, that the term "flow effects" has at times been used in relation to the high pace of asset
purchase programmes carried out in response to the COVID-19 crisis, for which only the envelope and
duration were defined at the time they were announced. From this perspective, flow effects help to
signal the central bank's commitment to providing ample policy accommodation and reassure market
participants about the presence of central banks as large and patient investors.
9.
The extraction of duration risk associated with the stock of securities held by the ECB loses potency
over time because the residual maturity (and hence the duration) of all securities shrinks over time.
And reinvesting maturing securities falls short in terms of making up for this loss. As the extraction of
duration risk smoothly recedes over time, the stock effects on term premia tend to recede. Moreover,
the size of our balance sheet will tend to decrease relative to other economic variables.
10.
Brainard, W.C. (1967), "Uncertainty and the Effectiveness of Policy", The American Economic Review,
Vol. 57, No 2, pp. 411-425.
11.
Coibion, O., Georgarakos, D., Gorodnichenko, Y. and van Rooij, M. (2019), " How Does Consumption
Respond to News about Inflation? Field Evidence from a Randomized Control Trial ", NBER Working
Paper Series, No 26106, National Bureau of Economic Research, July. Based on a survey of Dutch
households in which random subsets of respondents receive information about inflation, the paper
shows that an increase in inflation expectations leads to a sharp negative effect on durable spending
and that this is likely to be driven by the fact that Dutch households seem to become more pessimistic
about their real income.
12.
See the European Business and consumer survey results for April 2022 , which show a significant
realised and expected deterioration of households' financial situation and major purchases.
13.
See Bank of America's Global Fund Manager Survey, May 2022. Global growth optimism is defined as
the net share of fund managers expecting a stronger economy. It has reached its lowest point in
almost three decades.
14.
Lane, P.R. (2022), " The euro area outlook: some analytical considerations ", speech at Bruegel, 5 May.
15.
In September 2020, for example, I made the argument that "the risks of a policy overreaction are much
smaller than the risks of policy being too slow or too shy to react and the worst-case scenarios
materialising." See Panetta, F. (2020), " Asymmetric risks, asymmetric reaction: monetary policy in the
pandemic ", speech at the meeting of the ECB Money Market Contact Group, 22 September.
16.
Söderström, U. (2002), "Monetary Policy with Uncertain Parameters", The Scandinavian Journal of
Economics, Vol. 104, No 1, pp. 125-145.
17.
In previous speeches I have distinguished between good, bad and ugly inflation. Good inflation is
driven by domestic demand and wages consistent with our target, which monetary policy should seek
to nurture until that target is reached. Bad inflation reflects negative supply shocks that raise prices
and depress economic activity, which monetary policy should look through. Ugly inflation - the worst
type of inflation - is driven by a de-anchoring of inflation expectations, which monetary policy should
immediately stamp out. See Panetta, F. (2021), " Patient monetary policy amid a rocky recovery ",
speech at Sciences Po, 24 November, and Panetta, F. (2022), " Small steps in a dark room: guiding
policy on the path out of the pandemic ", speech at an online seminar organised by the Robert
Schuman Centre for Advanced Studies and Florence School of Banking and Finance at the European
University Institute, 28 February.
18.
Based on premia-adjusted one-year forward inflation-linked swap rates. Sources: Refinitiv, Bloomberg,
and ECB calculations.
19.
Levine, P. et al. (2008), " Risk management in action: robust monetary policy rules under structured
uncertainty ", Working Paper Series, No 870, ECB, Frankfurt am Main, February.
20.
ECB (2022), " April 2022 euro area bank lending survey ", 12 April.
21.
Recent survey data were weaker than expected. In particular, in April 2022 the Economic Sentiment
Indicator for the euro area declined significantly (from 114.5 in February 2022 to 105 in April), driven
by worsening confidence in industry, services, retail trade and construction, and among consumers.
22.
Industrial production (excluding construction) decreased sharply (by 1.8% month-on-month) in March
and currently stands 0.6% below the level it reached before the pandemic (in February 2020). Euro
area GDP growth in the first quarter of 2022 was 0.3%, and while there were growth spikes in a few
countries, in major economies GDP growth either slowed (Spain), halted (France and the Netherlands)
or contracted (Italy). In Germany growth momentum is low and weakening according to Destatis ,
which emphasised that "the economic consequences of the war in Ukraine have had a growing impact
on the short-term economic development since late February".
23.
Panetta, F. (2022), " Europe's shared destiny, economics and the law ", Lectio Magistralis on the
occasion of the conferral of an honorary degree in Law by the University of Cassino and Southern
Lazio, 6 April.