José Manuel González-Páramo: Non-standard monetary policy: five
questions about the exit
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, on the occasion of the Seminar at the European Economics and
Financial Centre, London, 6 November 2009.
* * *
Introduction1
I would like to thank the European Economics and Financial Centre (EEFC) for organising
this conference and giving me the opportunity to speak in front of such a distinguished
audience. This is the second time I have had the honour of participating in the EEFC series
of seminars; the first time being back in September 2006. It is always a pleasure to be invited
to address an audience again because it allows you to resume the dialogue already started.
Back in 2006 my speech focused on the many challenges that uncertainty poses for the
design of monetary policy. Today, I would like to focus on some questions related to the exit
from the ECB's non-conventional monetary policy.
There is no need for me to recall the start of the crisis in early August 2007, when tensions
originating in the US sub-prime mortgage market spread to international money and credit
markets, nor its intensification in mid-September 2008, following the filing for bankruptcy
protection by Lehman Brothers. While the full cost of the crisis has yet to be assessed, the
output contraction and job destruction observed so far (as well as the less readily
measurable social costs) have been on a scale unseen for more than half a century.
In order to contain the impact of the crisis on the real economy and preserve price stability,
central banks have engaged in an aggressive cutting of policy interest rates and have
introduced a number of non-standard monetary policy measures. At the same time,
governments have adopted large fiscal stimulus measures, while also making vast public
funds available to provide support to their banking and financial industries.
Recent data suggest that the massive response to the crisis by public authorities is bearing
fruit. The threat of a continuing free fall in activity in our economies has now receded and
there are signs that the global slowdown may be bottoming out. However, the crisis has
certainly not come to an end: uncertainty remains high and the economic data remain
volatile. Based on the information currently available, we expect the recovery to be gradual
and, at least in the short term, to continue to rely on a number of temporary factors, such as
past discretionary stimulus.
Even though the crisis is not yet over, during the last year we have developed the set of
principles and contingent courses of action that will govern the gradual and progressive exit
from the set of non-standard measures currently in place. Indeed, no orderly departure from
the current set of policies can be achieved in the absence of a well-designed and clearly
communicated exit framework. Moreover, if current public policies are ultimately to be
successful, the development of a credible exit strategy is almost as important as the nature
and magnitude of the policies themselves. It goes without saying that discussing the
appropriate design of an exit strategy should not necessarily be interpreted as signalling
imminent policy actions.
I would like to structure my speech today around five specific questions related to the exit
from the set of non-conventional monetary policy measures. First, I would like to discuss
"whence" we are exiting. For this purpose, I will briefly recall the main characteristics of the
Eurosystem's approach to non-conventional monetary policy. Then, I would like to elaborate
on "why" we need to exit such policy. I will then say a few words on "whither" we will exit,
particularly as regards the monetary policy implementation framework. I will then discuss
"how" we are going to exit the set of measures currently in place and, finally, "when" we will
do so.
Whence?
Following the intensification of the financial crisis in the autumn of 2008, inflationary
pressures rapidly receded, prompting the ECB to undertake a series of aggressive cuts to its
official policy rates. Between October 2008 and May 2009, the ECB's central policy rate - the
interest rate on the main refinancing operations - was lowered by a cumulative 325 basis
points. The speed and extent of the monetary loosening experienced over this period are
without precedent since the ECB took responsibility for the conduct of monetary policy in the
euro area. This is, of course, a rather short period, just over a decade. However, even if we
look at the much longer historical experience of the national central banks forming the
Eurosystem, such as the Deutsche Bundesbank, it is not possible to find anything similar.
The severity of the economic contraction, with the ensuing downside risks for price stability,
prompted the ECB to introduce additional measures that allowed it to ease monetary
conditions above and beyond what could be achieved through the interest rate instrument
alone. Thus, the ECB adopted the comprehensive set of non-standard liquidity measures
that together form what we call our "enhanced credit support" approach.
The enhanced credit support programme relies on four key types of measures, which I would
like to describe briefly:
1) Full accommodation of private banks' demand for central bank liquidity at a fixed
rate (determined by the central policy rate) and the conduct of additional longer-term
refinancing operations (LTROs), in particular - and for the first time - six and
twelvemonth refinancing operations.
The outstanding amount of LTROs increased from €150 billion in June 2007 to over
€600 billion at the end of 2008. Over the same period the total amount of
outstanding liquidity almost doubled, peaking at €850 billion on 2 January 2009. The
12-month operation conducted in June 2009 was, at €442 billion, the largest single
refinancing operation ever conducted by a central bank. It attracted the widespread
participation of counterparties, namely 1,100 financial institutions, which may also
have been a record.
2) The regular provision of liquidity in foreign currencies, notably the US dollar. Since
October 2008, these operations have been conducted with full allotment at a fixed
rate.
Again, this is unprecedented in central banking history, and illustrates the close
coordination and effective cooperation between major central banks over the last
two years.
3) The expansion of the list of assets eligible to be used as collateral in Eurosystem
credit operations.
In this respect, the Eurosystem was very different from other major central banks, as
it entered the financial turmoil with a broad list of eligible collateral. This also
explains why a further extension of collateral eligibility was not required until October
2008, i.e. after the collapse Lehman Brothers. In a financial crisis, the importance of
the ample availability of eligible collateral accepted by central banks can hardly be
overstated - after all, the most forthcoming of central bank refinancing operations
can be used by counterparties only to the extent that they hold eligible collateral.
4) Outright purchases of covered bonds.
The covered bond market, which has historically been an important source of
funding for banks in large parts of the euro area, had suffered heavily from the
financial crisis. The total sum allocated to the purchase programme - €60 billion,
representing about 5% of eligible outstanding covered bonds - may appear modest
compared with the size of the portfolios of government and private sector securities
built up by other central banks. However, it reflects the ECB's purpose to support
market functioning and to act as a catalyst for this market rather than as a
marketmaker of last resort. As is widely recognised, the goal of market reactivation has
been achieved, and maybe even more rapidly then expected. During the first four
months, the Eurosystem bought covered bonds for a total of over €20 billion, with
the total of up to €60 billion being targeted for June 2010.
These measures were designed with the objective of providing support to the banking sector
by: (a) helping the functioning of the money market, (b) easing funding conditions for banks,
and (c) improving market liquidity in segments of the private debt securities market
(specifically, the market for covered bonds) that represent an important source of funding for
euro area banks. Through these measures, the ECB aimed to mitigate the risk of systemic
illiquidity in the euro banking sector and to guarantee a steady flow of banking credit to euro
area households and firms.
It is sometimes said that the secret of success for a policy stimulus is that it must be T-T-T:
timely, temporary and targeted. Let me briefly elaborate on these three Ts.
It is generally recognised that since the start of the tensions, the ECB's response to the crisis
has been timely. Indeed, when widespread tensions threatened to bring the money market to
a halt in early August 2007, the ECB reacted rapidly by injecting €95 billion in an overnight
operation. After taking a number of additional measures in the course of the following year,
the ECB again responded swiftly to the intensification of the crisis in October 2008, by
announcing further exceptional measures. Similarly, the rapid and pronounced cuts in
interest rates after October 2008 represented a timely response to the occurrence of large
contractionary shocks.
While repeatedly recalling its commitment to maintaining non-standard measures for as long
as needed, the ECB has always stressed the temporary nature of its non-conventional policy.
The temporary character of these measures reflects their extraordinary nature and scale.
Indeed, the exceptionally disruptive effects of the crisis required equally exceptional policy
responses. However, measures that prove effective and appropriate in a crisis may not be
needed when normal conditions are restored. Even more importantly, the temporary nature
of the non-conventional measures is an important device to ensure the anchoring of
longterm inflation expectations.
Finally, the ECB's liquidity measures were specifically targeted to the banking sector. While
in the course of the crisis some central banks have decided to bypass the banking system
and lend directly to the real sectors of their economies, the Eurosystem has chosen to use
the banking sector as an intermediary in order to support the euro area economy as a whole.
The reason for concentrating on the banking sector stems to a very large extent from
structural features of the euro area economy, particularly the fact that its financial system is
still predominantly bank-based.
Indeed, bank loans account for a much larger share of financing to households and firms in
the euro area than in the Anglo-Saxon countries, where non-bank financial institutions and
capital markets provide alternative sources of funds. For instance, in 2007 the ratio of bank
lending to the private sector to GDP amounted in the euro area to almost 150%, compared
with 63% in the United States. By contrast, the ratio of outstanding debt securities issued by
the euro area private sector relative to GDP was about 80% in the euro area, while it was
more than twice as much in the United States.
The fact that the euro area financial system is predominantly bank-based implies that the
health of the banking sector plays a major role in determining the orderly functioning of
economic activity and the maintenance of financial stability. Thus, by easing funding
conditions in the banking sector, the central bank can effectively pursue its target of
guaranteeing steady access to credit for households and companies. Moreover, disruptions
to the inter-bank money market and to the banking system may have implications for the
stability of the monetary policy transmission mechanism, potentially preventing the central
bank from implementing its desired policy stance.
Following the implementation of the enhanced credit support framework, the size and
complexity of the Eurosystem balance sheet has significantly increased. In June 2007, just
before the start of the crisis, total assets of the Eurosystem amounted to around 10% of
area-wide GDP.2 By January 2009, the size of the balance sheet had almost doubled,
reaching 19% of GDP. Subsequent improvements in money market conditions have led to a
reduction in the amount of total assets, but they remain at a higher level (16% of GDP) than
in the pre-crisis period. The expansion of the Eurosystem balance sheet was driven by
changes in autonomous factors, as well as by the introduction of non-standard measures.
It is difficult to assess the impact of our non-conventional policy precisely, but there are some
clear signs that the measures are having positive effects. In particular, the spreads between
unsecured term interest rates and overnight interest rate swaps in the money market have
declined significantly since last autumn and are now back at levels last seen before the
bankruptcy of Lehman Brothers. Together with the policy rate cuts, this has contributed to a
substantial decline in interest rates on loans to households and firms. Also, banks have
benefited from the tightening of spreads in the market for covered bonds, while issuance in
the primary market has increased dramatically since the summer.
At the same time, we have to admit that growth in aggregate lending has not turned around.
Although there have been recent signs that the slowdown in lending to households has come
to a halt, the growth rate of loans to non-financial corporations has continued to moderate.
Seen in context, the recent developments in loans to firms appear to be broadly in line with
past regularities in bank lending behaviour, particularly at turning-points in the business
cycle. Indeed, loans to firms tend to lag GDP growth by about three quarters. This may be
related to the fact that non-financial corporations usually see their cash flows improve early in
an economic upturn and thus tend to finance working capital and fixed investment with
internal funds first, and only later with external financing. In addition, when macroeconomic
conditions are weak, the dynamics of bank loans are affected by demand-side factors.
Having said this, it is important to closely monitor developments in credit in order to assess to
what extent supply-side constraints may play a role in limiting credit availability.
Why?
As I mentioned earlier, the exceptionally disruptive impact of the crisis has required
extraordinary responses from public authorities. However, as economic and financial
conditions normalise, it is important to withdraw the currently exceptional degree of monetary
accommodation, implemented through both historically low key policy rates and enhanced
credit support measures.
Indeed, should a significant improvement in the outlook for economic activity not be
accompanied by an adequate adjustment in the policy stance, the current monetary stance
may become excessively accommodative, thereby giving rise to risks to price stability.
The experience of the past decade has led many economists to conclude that protracted
accommodative monetary conditions, especially when they become widespread at the global
level, may make access to credit in international financial systems too easy. Easy credit
availability can in turn depress interest rates across the maturity spectrum and lead to
severely distorted financial asset prices as agents engage in increasingly speculative
behaviour. Thus, preventing the monetary policy stance from becoming excessively
accommodative is important not only to directly preserve price stability, but also to avoid the
emergence of financial imbalances that may - if they prevail for too long - eventually give
rise to episodes of macroeconomic instability.
Moreover, the long-term success of non-conventional policies depends on the policy-maker's
ability to pull off a difficult balancing act: to provide massive stimulus to the economy in the
short-term, while keeping long-term private sector inflation expectations firmly anchored. The
failure to preserve the anchoring of long-term inflation expectations would be self-defeating
for non-conventional policies. In such a case, the beneficial effects on the economy of the
latter policies could be neutralised by an array of adverse factors, including increased
inflation risk premia, interest rate volatility and Ricardian effects on consumer spending.
In addition to these considerations of a more macroeconomic character, there are other
reasons - related to distortions in the functioning of markets and the behaviour of individual
agents - why central banks should not retain non-standard liquidity measures once financial
and market conditions render them unnecessary.
First, the protracted provision of central bank liquidity may reduce the incentives for
commercial banks to resume their market-based funding activities. Indeed, as a result of the
non-standard liquidity provision in euro and other currencies (notably, the US dollar) during
the crisis, the Eurosystem has significantly increased its involvement in financial
intermediation in the euro area.
In fact, the Eurosystem effectively intermediates liquidity flows between banks in order to
mitigate the effects of dysfunctional money markets on the funding liquidity of solvent banks.
While justified by the severity of the crisis, this increased intermediation role is, of course, not
fully consistent with the principles under which a market-oriented economy like the euro area
should normally operate. Thus, with the return of the economic and financial preconditions
for normal market functioning, incentives for interbank lending should be restored, so that
banks can resume their core functions.
More generally, the protracted provision of central bank liquidity at favourable conditions may
end up propping up banks that are unable to fulfil their funding needs, even under normal
market conditions. This may give rise to concerns about whether the necessary adjustments
and restructuring in the banking system have taken place.
Some considerations can also be made with regard to the collateral framework and to certain
practices on collateral use that have emerged over the past two years. As mentioned earlier,
the Eurosystem has always accepted a broad range of public and private securities,
including unsecured bank bonds and asset-backed securities (ABS), as collateral in its
refinancing operations. Having an extensive definition of eligible collateral has proven very
useful during the crisis to mitigate refinancing risks for several classes of assets.
Indeed, in the course of the crisis counterparties have made active use of the refinancing
opportunities provided by the Eurosystem's refinancing operations and have deposited as
collateral some eligible assets for which market liquidity had basically dried up. In particular,
many ABS transactions have not been placed in the public market, but have been retained
onto the balance sheet of the originator and/or privately placed to be used as collateral in
central bank facilities. At the same time, banks have economised on the use of the most
liquid categories of assets (such as central government bonds) in order to save them for
private repo transactions. As market conditions normalise, banks will need to make efforts to
overcome the present large-scale use of self-originated ABS as collateral in Eurosystem
credit operations, and instead place these securities with investors. This requires efforts to
meet investor standards, in particular by improving the transparency, simplicity and the
degree of standardisation of transactions.
The Eurosystem is prepared to contribute as far as it can to the reactivation of the ABS
markets. The eligibility criteria and risk control measures of the Eurosystem's collateral
framework are an important tool in this respect. Reactivating ABS markets would be, first of
all, in the interest of banks as it would restore a major source of funding. It would also benefit
the Eurosystem, as it would reduce the extra financial risks resulting from the inevitable links
between counterparties and the self-originated ABS submitted as collateral. The ECB is
aware of these risks, and has already mitigated them through a number of specific
measures, such as the prohibition of some types of close link, the raising of the rating
threshold for ABS, an increase in valuation haircuts and the phasing-out of multi-layer
securitisations. Still, we consider that the reactivation of the ABS market and the associated
reduction in the use of self-originated ABS would be ultimately the only way forward in this
context.
Whither
Interest rates are currently at historically low levels, reflecting rapid and deep cuts between
the autumn of 2008 and the spring of 2009. Once economic activity normalises and the
outlook for price stability starts pointing to upward risks, adjustments in the stance of
monetary policy in line with the maintenance of medium-term price stability are to be
expected.
While there is no doubt that the return to normality of our economies will need to be
accompanied by a normalisation of monetary conditions, the key question is what we mean
by "normal" in the post-crisis environment. Indeed, there is significant empirical evidence
showing that financial crises tend to have large and long-standing costs in terms of output
and employment and tend to be followed by persistent declines in asset prices.3 In the
specific case of the current crisis, there are increasing concerns that its cost in terms of lost
financial, physical and human capital all over the world may prove very substantial. As a
result, the crisis may end up having a protracted impact on the rate of potential growth of a
number of economies, including the euro area.
Therefore, in the post-crisis world, we may operate in an environment in which the dynamic
properties of our economies are persistently affected, so that returning to "normality", as we
knew it before, will take a long time. As a side effect, the statistical regularities underlying the
estimates of models and indicators (e.g. the output gap and the interest rate gap) often used
for policy analysis may not be as stable as in the past. At the ECB we have traditionally been
reluctant to rely exclusively on models and summary indicators of the monetary policy
stance, so we are not concerned about the reliability of any specific indicator. Yet, we share
the more general concern that in the future decisions will be taken in an environment
characterised by high uncertainty and reduced reliability of the monetary policy maker's
conventional information set.
Faced with increased uncertainty, central banks are at their best when they clearly commit to
a well-defined goal and pursue it consistently and independently. In the case of the ECB, our
strategy includes a specific quantitative definition of price stability: annual inflation of below,
but close to, 2% in the Harmonised Index of Consumer Prices over the medium term. This
definition sets a clear benchmark against which decisions must be made.
Thus, in a period of increased uncertainty it is crucial for the ECB to set its interest rate
instrument at any point in time at the level which is appropriate to ensure the achievement of
its primary objective. The assessment of the risks to medium-term price stability based on a
comprehensive and robust set of indicators will prove essential in guiding monetary policy
decisions in the future. In this respect, the ECB's choice of a full-information approach resting
on two complementary pillars (an economic analysis and a monetary analysis), with its
advantages in terms of robustness is likely to prove very beneficial in providing insurance
against increased model and paradigm uncertainty.
Turning now to the monetary policy implementation framework, we should recall that prior to
the escalation of the financial crisis in September 2008, the operational framework worked
well. Hereafter, many exceptional measures were taken to support the availability of liquidity
and the recovery of the euro area economy. Looking ahead, as conditions in the financial
markets normalise further, not all these liquidity measures will be needed to the same extent
as during the crisis. Therefore, one should envisage a situation in which the main operational
features that were in place prior to the crisis are restored, while of course also bearing in
mind the lessons learned from the crisis.
In particular, we seek to revert to a situation in which the one-week main refinancing
operation is the main tool for steering money market rates and we act as "rate-takers" in the
longer-term money market. In addition, under normal circumstances, central banks also do
not provide liquidity in foreign currency. This does not mean, however, that contingency or
emergency measures to be activated under extraordinary conditions cannot remain in place.
Finally, the use of using self-originated paper as central bank collateral should be considered
as an anomaly under normal market conditions.
How?
The stance of monetary policy, as reflected in short-term interbank interest rates, can
obviously be tightened through an increase in key policy rates, or through a tighter liquidity
supply, or through a combination of both. It is too early at present to say which approach, or
combination of approaches, should be followed, as it will depend on the circumstances
prevailing at the relevant moment in time.
With regard to the withdrawal of non-standard liquidity measures, it is useful to distinguish
again between the main different types of measure.
First, for the non-standard refinancing operations, there is an obvious built-in mechanism that
facilitates their removal, as the operations mature at pre-specified dates and can then be
replaced by conventional refinancing operations, if needed.
Second, as with non-standard euro refinancing operations, the provision of foreign currency
liquidity does not need to be renewed when it is considered that it is no longer warranted. In
this context, let me remind you that the exit from this specific measure has already started:
owing to lack of demand, we have already discontinued foreign currency-providing
operations with longer maturities.
Third, it has been made clear that the widening of the collateral framework is temporary.
More precisely, its remaining into effect is linked to the conduct of 12-month LTRO in
December 2009. Hence, the widening of the collateral framework will be naturally phased out
in December 2010, unless otherwise decided.
Finally, in relation to the covered bond portfolio, there is no particular need to dispose of the
purchased bonds at any future moment in time, as it does not interfere with monetary policy
implementation. We could therefore decide to hold the portfolio until maturity and let it
gradually shrink over time as a result of redemptions. Alternatively, the portfolio could be
disposed of in a gradual way that would make it possible to avoid market distortions. In any
case, the alternative options can be considered again once the entire portfolio has been
established.
Regardless of the specific modalities adopted for the exit strategy, key principles of "how" to
phase out existing measures should in any case be timeliness and gradualism. Indeed, the
stance of monetary policy should be normalised and the non-standard measures withdrawn
in parallel with the gradual improvement in economic and financial conditions.
Let me also stress that there are no technical obstacles to the implementation of our exit
strategy. In any case, we have the instruments to allow us to actively withdraw liquidity.
Longer-term liquidity-absorbing operations could be envisaged in a scenario where it is clear
that the need to absorb persists for a certain period of time, and where a significant
tightening in monetary policy is needed. In this case, long-term liquidity absorption could be
used to quickly restore a deficit situation along with an increase in interest rates. It may be
recalled that many central banks worldwide constantly and successfully implement monetary
policy through liquidity-absorbing operations.
When?
In discussing when to exit non-conventional monetary policy, we may distinguish here
between the traditional interest rate instrument and the multiple non-standard liquidity
measures. For the stance of monetary policy, the answer to this question is simple - at least
in theory. Given the institutional policy of the ECB, the obvious point in time to tighten the
policy stance is when, based on the analysis of the outlook for economic activity and
inflation, there is evidence of emerging upside risks to price stability. At that stage, the
interest rate should be increased at the pace necessary to ensure price stability in the
medium term. However, identifying the right moment in time to start a tightening phase is
difficult under normal conditions and even more so when the assessment of risks is, as in the
current environment, surrounded by heightened uncertainty.
Besides being technically difficult, identifying the exact moment when the balance of
inflationary risks shifts could be complicated by the "noise" introduced by public utterances
and pressures aimed at influencing the decision of the central bank. At the ECB, we still have
memories of the difficult environment we faced in 2005 when, after leaving the central policy
rate unchanged at 2% for two and a half years, we decided to start tightening the policy
stance. With hindsight, it is generally recognised that our decision was appropriate and that it
served to anchor long-term inflation expectations.
A past record of getting turning-points right is, however, no guarantee of success in the
present context. Exceptionally high uncertainty implies that the exit from the current
nonconventional monetary policy measures will need to be based on the analysis of a broader
set of indicators than usual. Nevertheless, no matter how large the number and variety of
indicators, one cannot exclude the risk of exiting from the non-conventional measures too
soon or too late. Both situations would be dangerous.
If a central bank starts exiting prematurely, it will be hard for it to reverse its course, should a
deterioration in economic conditions materialise again. Indeed, historical experience shows
that there is a certain element of irreversibility in the removal of non-conventional measures.
This is because the effectiveness of non-conventional policy depends to a large extent on
how long the policy is expected to stay in place. For instance, if an exceptional measure to
increase liquidity supply to the banking sector is expected to be short-lived, banks are
unlikely to extend additional credit to the private sector.
More generally, even the appearance of a lack of commitment to its non-conventional
measures (or simply of being uncomfortable with them) can prove self-defeating. It has been
argued that, despite the announcement that the zero interest rate policy introduced in 1999
would be maintained until deflation was over, signs that the Bank of Japan was
uncomfortable with this policy (culminating in a 25 basis point increase in the call rate in
August 2000) prolonged the Japanese deflation unnecessarily.4
At the same time, and here is the tricky issue, if the commitment is to be credible, it must
also be realistic. Indeed, unless severe deflationary pressures become deeply entrenched in
expectations, the public may not believe that public authorities are seriously committed to
pursuing non-conventional measures when these measures are of such a large magnitude
as to appear untenable for the balance sheet of the central bank or for the sustainability of
public finances.
So much for the risk of exiting too early. There is also the opposite risk of exiting too late.
Exiting too late is dangerous because the public may lose faith in the central bank's
commitment to low inflation. We know - from our own historical experience in the 1970s and
early 1980s - that, once public sector inflation expectations have become destabilised, it is
extremely difficult and costly (in terms of output and job losses) to bring them back under
control. By contrast, a credible commitment to an explicit inflation objective helps to anchor
inflation expectations to the desired level of inflation, and this anchoring contributes in itself
to delivering price stability. It is clear, then, that, as long as they remain well-anchored at the
desired level, expectations can greatly facilitate the tas