Peter Praet: The European Central Bank's monetary policy - past
and present
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at the
Febelfin Connect event, Brussels/Londerzeel, 16 March 2017.
* * *
In recent years it has been often said that the ECB has become the "only game in town" for
stabilising the euro area economy. As governments have had to consolidate their fiscal positions,
there has been an unprecedented onus on monetary policy to support aggregate demand. The
ECB has responded to this challenge and acted decisively to secure price stability in face of an
economic and financial crisis unparalleled in post-war history.
But this role, and the unconventional measures we have adopted to execute it, has inevitably put
monetary policy more in the spotlight. We are facing intense scrutiny as to how our policy works,
its necessity and the side effects it causes.
So what I would like to do in my remarks is, first, to explain the current monetary policy of the
ECB and its evolution during the crisis. The unconventional measures we have deployed, such
as negative rates and asset purchases, are the outcome of a protracted crisis that has unfolded
in multiple waves - one that has both worsened the economic situation facing monetary
policy and constrained the instruments we have available to respond to it.
I will then go on to describe how these unconventional measures are working to ease financing
conditions for firms and households, especially through the bank lending channel, and ensure a
sustained recovery for the euro area economy. Finally, I will touch on the side effects of our
measures on the banking sector, and how they can be addressed to ensure a continued, robust
transmission of our monetary policy.
While my focus will be on what monetary policy has achieved during the crisis, it is also
important to underline what we cannot do: central banks cannot remain the "only game in town"
indefinitely. Monetary policy can bring output back to its potential level, and it may even be able to
affect that potential by unwinding hysteresis effects, but it cannot durably raise long-term growth
- which was on a declining trend even before the crisis. That requires further, determined
progress with structural and institutional reforms.
The phases of the crisis
In 2008 the global economy faced a crisis caused by the coincidence of two trends.
The first was the bout of over-optimistic expectations which took hold in several advanced
economies in the pre-crisis years, reinforced in the euro area by a renewed sense of security
and economic prosperity following the launch of monetary union. Despite slowing potential
growth, agents in a number of economies overestimated their future income and borrowed
against it, accumulating excessive debt. In some countries this over-leveraging was centred on
firms, in other countries on households and in others still on the state. Banks acted as the
intermediaries in both creditor and debtor economies.
This new environment would probably not have produced such aggressive risk-taking, however,
had it not been for the second trend: the parallel process of financial liberalisation and
deregulation across advanced economies which encouraged financial overextension and rapid
credit growth. In the euro area, financial integration also triggered an expansion in cross-border
financial flows, adding to the forces created by the waxing global financial cycle. The consequent
misallocation of resources into unproductive sectors only worsened the underlying growth
picture.
So when this reality finally bit in 2008, monetary policy was left facing a uniquely challenging set
of conditions: an "expectations gap" which had left firms and households overleveraged and in
urgent need of balance sheet repair, coupled with a "credit gap" as overextended banks began
their necessary restructuring and deleveraging - in other words, a so-called balance sheet
recession. These conditions laid the ground for the subsequent evolution of the crisis in the euro
area, which has unfolded in three main phases, each of which has required a different monetary
policy response.
The first phase was the immediate liquidity crisis triggered by the turning of the global financial
cycle and the subsequent collapse of Lehman Brothers. As in other advanced economies, euro
area banks faced uncertainty about the scale of their exposure to subprime products, prompting
a sudden stop in the availability of money market funding for many financial institutions and a
systemic rush to cash. Central banks faced an imminent risk of asset fire sales by credit
institutions to meet maturing obligations, in the process depleting their balance sheets and
initiating a steep contraction in credit.
The ECB's response was to lower its main refinancing rate to the then record low of 1% in May
2009 and to provide liquidity elastically to the banking sector, at both increasingly long durations
and against a wider range of collateral. Our balance sheet expanded as central bank liquidity
substituted for the malfunctioning interbank market.
But though monetary policy was able to avert the collapse of the financial system and prevented
a much deeper recession, the Lehman episode nonetheless left deep scars on the banking
sector, which the euro area was unable to heal as swiftly as other jurisdictions. Crucially missing
was a truly integrated banking system that could share risk across countries, with a harmonised
resolution framework and a European public backstop. Thus the onus fell onto sovereigns to
support their national banking sectors, strengthening the two-way risk between European banks
and their national governments.
This created the conditions for the second phase of the crisis: the sovereign debt crisis of 2011-
12 and its amplification through the "bank-sovereign" nexus. As sovereign borrowing costs
spiked, banks' exposures to selected governments came under intense market scrutiny. The
banking systems in vulnerable countries, representing almost 35% of euro area GDP, lost
access to affordable wholesale funding. Intermediation retreated behind national borders, and
with perceptions of redenomination risk on the rise, financial markets underwent severe
geographical fragmentation.
The result was a serious disruption in monetary transmission across different parts of the euro
area, which prevented our intended accommodative policy stance from reaching the economy.
Hence we responded to this fragmentation in two ways.
First, as per the Lehman shock, by compensating for sources of market funding that had
suddenly become unavailable, which now also included bank bonds. We achieved this by
lengthening the maturity of our operations to three years in November 2011, as well as by further
expanding the range of eligible collateral that could be pledged against central bank money.
Without such action there would, once more, have been a risk of banks being forced into fire
sales and rapidly contracting credit to the economy. Generalised capital controls in vulnerable
countries would have been inevitable.
Second, by removing the redenomination risk expressed in sovereign spreads, which was
distorting the local pricing benchmarks used to price assets and credit. Our main tool here was
the announcement of our conditional Outright Monetary Transactions in September 2012, which
acted as a powerful circuit breaker against self-reinforcing fears in sovereign bond markets. This
successfully truncated the worst tail of the distribution of possible macroeconomic outcomes.
But the sovereign debt crisis nonetheless left a damaging legacy for the economy - and this laid
the ground for the third phase.
The ECB's measures since summer 2014
As the euro area entered a prolonged slump, banks in large parts of the euro area began to
engage in a drawn-out process of deleveraging. This represented a necessary - and indeed
overdue - process of adjustment for banks that had overleveraged in the run-up to the crisis. But
rather than reducing risk-weighted assets by raising capital or disposing of non-core assets,
banks instead began to reduce lending. In those countries most severely hit by the sovereign
debt crisis, the risk-adjusted returns on loans had declined to the point where banks had a strong
incentive to redeem loans and downsize.
The euro area faced a chronic malfunctioning of bank-based transmission and growing signs of
a credit crunch: by end-2013 the annual growth rate of loans to the private sector had contracted
by more than 2%. Against that background, inflation began a prolonged downward drift. The ECB
cut rates twice in 2013 in response, reaching 0.25% in November, and introduced forward
guidance to better insulate euro area financial conditions from the diverging US monetary policy
cycle. This policy helped decouple the risk-free curve from outside influences and made it more
appropriate for the underlying conditions we were facing. In early 2014 the recovery appeared to
be back on a firming path.
By mid-2014, however, it was clear that the economic recovery had lost momentum, removing a
key driver of the reflation scenario we had anticipated. The sharp fall-off in oil prices that began in
late summer added further disinflationary pressures. Given the weak underlying trend in inflation,
we saw a growing risk that low inflation could de-anchor inflation expectations and produce
second-round effects, creating a self-reinforcing negative spiral. Without decisive monetary
policy action, the euro area could have faced deflation.
The ECB therefore faced a pressing need to reinforce the degree of policy accommodation in
view of persistently weak inflation. Yet here we confronted an instrument limitation.
With interest rates already not far from zero, our ability to use conventional monetary policy to
provide additional accommodation was now constrained. And moreover, the pre-crisis slowdown
in potential growth, coupled with the negative effects of the crisis on investment and private
sector balance sheets, appeared to have imbalanced saving and investment, and depressed the
real equilibrium interest rate to very low levels. Hence even cutting rates to low (positive) levels
would provide insufficient stimulus.
Under these conditions, the ECB had to resort to a new approach to expand its monetary stance,
one based less on adjusting its main refinancing rate, and more on directly influencing the whole
constellation of interest rates in the economy that are relevant for private sector financing
conditions. This strategy has been articulated in three instruments.
The first is the negative interest rate on our deposit facility, which - in a context of excess
reserves - has brought overnight rates down to negative levels and hence provided additional
effective stimulus. The fact that policy rates can indeed turn negative has also contributed to
flattening the short to medium end of the yield curve, thereby easing broader financing conditions
by removing the upward bias to yields that comes from the perception that rates can only go up,
not down.
The second instrument is the asset purchase programme (APP) of private and public sector
securities, which has helped further depress the term structure of interest rates by compressing
risk premia out along the yield curve. This effect takes place directly in the market segments
where we intervene, namely covered bonds, asset-backed securities (ABS), sovereign and
corporate bonds. And higher asset prices spill over, through portfolio rebalancing, into
nontargeted markets as investors move up the risk and maturity ladder.
Importantly, the stimulus from these two instruments reaches the economy independently of
whether financing is dominated by banks or capital markets. A broad easing of financial
conditions leads to lower funding costs for banks, while asset purchases depress the pricing
kernels used in each country to price local credit, in particular the risk-free yield curve. Both lead
to lower interest rates for borrowers. At the same time, as asset prices rise banks have a
stronger incentive to provide loans to the real economy in the first place.
Indeed, banks operate on the basis of the same relative-value logic as non-bank market
participants: a decline in fixed-income securities earnings encourages banks into the same type
of portfolio reallocations that affect investors in the capital market, rebalancing their portfolios
towards assets with higher risk-adjusted returns, including loans. And this also applies to the
excess cash reserves that are created as result of our asset purchases, where the incentive to
invest in higher-yielding assets is intensified by our negative rate policy.
The third instrument is our targeted longer-term refinancing operations (TLTROs), which are
specifically aimed at galvanising bank lending to the private sector in a context of ongoing bank
deleveraging. Banks have been able to borrow at the interest rate on our deposit facility, but only
on condition that they demonstrate strong performance in loan origination. The intention was to
introduce more competition in the market for bank loans, which in turn squeezes unit lending
margins and borrowing costs for the real economy.
This set of measures - which works as a mutually reinforcing package - has proved adaptable
to the shocks the euro area has faced since its launch. Indeed, the third stage of the crisis has
not only included the disinflationary consequences of the sovereign debt crisis, but also an
unprecedented collapse in energy and commodity prices, with its potentially destabilising effect
on inflation expectations; and a slowdown in emerging market economies in 2015 which weighed
on global trade. In each case we have been able to recalibrate our measures in terms of size and
across instruments so as to continue providing sufficient accommodation to the euro area
economy.
The impact of our measures
The evidence for the effectiveness of this strategy is clear. Our monetary policy has contributed
to a major easing of euro area financing conditions and, through this channel, to a more robust
and sustained economic recovery.
Since mid-2014 bank lending rates have dropped to historical lows for both firms and
households, and pass-through regularities appear to have returned. Bank lending volumes have
also been on a continuous upward trend, though they remain relatively weak: in January this year
lending to households grew at the fastest rate since May 2011 - 2.2% on an annualised basis -
while corporate lending, as in December, grew by 2.3%, its highest reading since 2009. And
behind this picture of overall credit easing is one of substantial convergence - both inter-country
and intra-country.
Granular data confirms that both the level and dispersion of lending rates has declined
considerably in vulnerable countries and more strongly than elsewhere, thereby further reducing
asymmetries in the overall policy transmission across country groups. Rate dispersion between
large and small loans also largely vanished between vulnerable and other countries towards the
end of last year, implying a convergence in financing conditions among different types of firms,
especially for small and medium-sized enterprises (SMEs).
Indeed, our latest survey on access to finance by SMEs shows further improvements in the
availability of external sources of finance and the willingness of banks to provide credit at lower
interest rates. "Access to finance" is now considered the least important concern for SMEs,
admittedly with some divergence across countries. SMEs in Greece continued to perceive it as a
very important problem but, encouragingly, a score close to the euro area average was reported
by SMEs in Italy, Ireland, Portugal and Spain.
Our measures have helped induce this broad easing of borrowing conditions very much through
the channels we expected.
On the liability side, bank funding conditions have eased considerably, with the average cost of
funding in the euro area reaching historical lows of around 40 basis points. Very low short-term
rates have encouraged banks to rebalance their liability structures away from more expensive
debt securities and towards deposits, providing funding cost relief. But there are of course limits
to such substitution - namely the incoming requirement to hold a minimum amount of eligible
liabilities and own funds (TLAC/MREL) - so it is important that wholesale funding costs have also
come down substantially. Our outright purchases under the APP have tightened spreads on
covered bonds and ABS, while rates on senior unsecured bank bonds have fallen due to the
portfolio rebalancing effects of the APP.
This positive effect of monetary policy on wholesale funding conditions is confirmed by the Bank
Lending Survey (BLS). Close to two-fifths of banks surveyed in the October 2016 BLS reported a
net improvement in their market financing conditions owing to the APP - up from one-fifth in the
April survey - in particular for financing via covered bonds and unsecured bank bonds, but also
via ABS issuance.
The TLTROs, too, have directly lowered term funding costs, especially for banks in vulnerable
countries, since those that draw on these operations have been able to substitute more
expensive wholesale debt for longer-term central bank liquidity. 40% of the banks surveyed in the
latest BLS round reported that they have used TLTRO funds for substituting maturing debt. And
the incentives embedded in the TLTROs have ensured a pass-through to customers: ECB
analysis confirms that TLTRO bidders in vulnerable countries have lowered lending rates more
than their non-participating peers.
On the asset side, the flattening of the term structure of interest rates seems to have exerted
strong downward pressure on bank lending rates, especially in countries that were more affected
by the sovereign debt crisis. ECB pass-through models show that, since the launch of our credit
easing package, the decline in lending rates in Spain and Italy in particular has been much
stronger than can be explained by falling market rates alone. Tightening sovereign spreads help
explain much of the observed fall.
This effect, paired with the credit impulse provided by the TLTROs, has also helped boost
competition among banks and put further downward pressure on lending rates. Evidence from
the BLS confirms that rising competitive pressures have been a key contributor to margin
compressions over the last two years. Purchases of corporate bonds are also a factor: banks
facing substitution of bank loans by corporate bonds have reported higher competitive pressures
and stronger margin compressions on loans to large firms.
There is some evidence, too, that as prices have risen banks have rebalanced their portfolios
away from sovereign bonds and towards loans. The increase in bank credit to the private sector
has been counterbalanced by a decrease in credit to general government. Banks responding to
the BLS last year indicated that they used the additional liquidity from APP-related sales for
granting loans, potentially responding to the incentives created by our asset purchases and
negative interest rate policy.
ECB staff research finds that banks' reactions to holdings of excess liquidity have changed due
to the charge on the deposit facility: cumulated bank lending in less vulnerable countries has
been one percentage point higher than it would have been otherwise.
As borrowing conditions for the real economy have loosened, economic activity has followed.
Whereas the 2010-11 recovery was based almost exclusively on net exports, the euro area is
now experiencing a recovery based predominantly on domestic demand. In fact, growth in the
euro area was previously closely correlated with the strength of international trade, but that
relationship has weakened recently. Monetary policy is contributing to higher domestic absorption
through all three classical channels.
The strong recovery in consumption has been bolstered through the income channel, since
falling interest rates have supported net borrowers, who tend to be liquidity-restrained and have a
higher marginal propensity to consume. Expansionary effects are also visible through
t h e intertemporal substitution channel: in particular, easier borrowing conditions have
encouraged households to bring forward durable consumption, and firms' investment, through
credit.
Consumption of durables has rebounded in recent years and its growth, especially in countries
where credit was previously very tight, is closely correlated with the improvement in credit
conditions as recorded in the BLS. Investment has responded more slowly to low interest rates,
yet monetary policy is helping create the conditions for a stronger investment revival through its
overall effect on the economy, sometimes called the "accelerator effect". Production and selling
price expectations are rising as aggregate demand picks up; corporate profitability is increasing;
and financing conditions remain extremely favourable.
Finally, housing markets are now moving into an expansionary phase in most euro area
countries, which should also support consumption going forward via the wealth channel.
As a result, we now see the economic recovery continuing at a moderate, but steadily firming
pace, and broadening gradually across sectors and countries. Sentiment indicators suggest that
the cyclical recovery may be gaining momentum. Consequently, our latest staff macroeconomic
projections foresee annual real GDP increasing by 1.8% in 2017, 1.7% in 2018 and 1.6% in 2019
- a slight upward revision this year and next compared with the previous exercise. The risks
surrounding the euro area growth outlook have also become less pronounced, although remain
tilted to the downside due to global factors.
Implications for the financial sector
So there is no doubt that our measures are having their desired effect. Yet unconventional
monetary policy can have side effects as well, and especially for the financial sector.
One key concern is their impact on banks' profitability - which remains generally weak in the
euro area - and especially on net interest income. Asset purchases flatten the yield curve and
reduce the returns on maturity transformation; and the negative interest rate policy de
facto flattens the curve further, since the zero lower bound that banks typically apply on deposits
means that a large share of bank liabilities no longer reprice when market rates fall. Bank lending
rates however typically do, compressing loan-deposit margins.
Consistent with this, margins between loan and deposit rates on new business narrowed in 2016
and may tighten further as loan rates continue to decline but deposit rates increasingly stack up
against zero. More than half of the new deposits held by corporations and close to 40% of those
held by households are de facto no longer remunerated. Slightly more than 40% of the stock of
corporate deposits and 35% of household deposits have virtually zero return.
This is clearly a challenging situation for banks, but so far its impact on profitability has been
contained, since monetary policy has countervailing effects on bank balance sheets. ECB
analysis suggests that lower net interest margins are being partly offset by higher asset
valuations and a more robust economy - which in turn boosts lending volumes and leads to
lower provisions and impairments for banks. And more generally, our policy measures create a
faster recovery with higher inflation, which implies a faster return to monetary policy
normalisation. Such expectations are now one factor buoying bank share prices.
Still, given the dominant role of net interest income in banks' earnings and the staggered pass-
through of low rates into lending margins, profitability is likely to remain vulnerable for some years
to come, which raises the question of how the banking sector should best adapt. In my view, it
would be misguided for banks to wait for changes in monetary policy to come to the rescue.
Even in a normalisation scenario, the pre-crisis banking world is unlikely to return. Banks face
new structural and technological challenges that they have to confront, in particular in terms of
raising operational efficiency.
Though the efficiency of the euro area banking sector has improved since the crisis, operating
costs remain generally high. This is especially apparent when one compares the cost-to-asset
ratios of some national banking sectors with those of banks in the Nordic countries. Sweden and
Denmark, for example, have cost-to-asset ratios of around 1, whereas in France and Germany
the ratio is closer to 1.5 and in Italy nearly 2. Such cost structures represent vulnerability in an
environment where traditional bank business models are under threat, and where banks are
facing increasing competitive pressures from new fintech entrants, especially in areas such as
retail payments, where they previously enjoyed healthy margins.
The reasons for these differences are complex, but they are partly the result of overcapacity in
some national markets, leaving banks with high fixed costs. Hence rationalisation and
consolidation within the sector appears a key ingredient in relieving cost pressures. While there
has been some movement in this area since the crisis - the number of credit institutions in the
euro area fell by 19% between 2008 and 2015 and the number of branches declined by 16%
- concentration indices in some markets remain low, and consolidation has largely taken place
within countries, reducing the benefits of cross-country diversification.
This is concerning, since it suggests that euro area banks are not yet in a position to exploit the
economies of scope and scale that should be possible in a truly integrated banking sector,
leaving a banking landscape that remains fragmented along national lines. And despite the
launch of banking union, this trend is actually worsening: cross-border mergers and acquisitions
accounted for just 9% of total transactions in 2016, against 15% for the period 2000 to 2015.
The still-unfinished state of banking union is one reason why. Two factors make it difficult for
banks to execute a European balance sheet strategy. First, the end scenario for banks in terms
of public risk-sharing is not yet clear, not least for deposit guarantee schemes. Second, the euro
area is not yet fully treated as a single jurisdiction for the purposes of bank regulation and
supervision, which creates barriers to cross-border activity.
The latter means, for example, that cross-border euro area exposures are still considered
as international exposures from a regulatory perspective, which may lead to additional capital
charges for systemically important banks. Banking groups seeking to optimise their liquidity and
capital within the euro area also face frictions to fungibility, be it liquidity waivers or requirements
to relocate staff if different parts of the balance sheet are reshuffled among subsidiaries. All this
reduces the gains to operating as European banks.
What I would ideally like to see - as a monetary policymaker - is a banking union that allows
banks to operate as truly European entities, and banks taking advantage of the cost-cutting
opportunities this provides. This would guarantee a healthier, more profitable sector that can
transmit our monetary policy smoothly to the real economy across the cycle. And it would
increase macroeconomic risk-sharing, leading to a more resilient monetary union.
The extent to which we are able to achieve such a new banking landscape is, in my view, the
litmus test of whether we have completed a genuine banking union.
Looking forward
Faced with a prolonged crisis, the ECB's unconventional policy measures have been essential to
provide additional accommodation to the economy and prevent a self-sustaining fall in inflation -
and they have been a clear success. Easier credit conditions have fed into a domestic
demandled recovery that has spread across countries and sectors. The economic outlook today is now
better than it has been for many years.
This assessment was confirmed by the Governing Council at its last monetary policy meeting.
Compared with our previous forecast round in December, we are now more confident in the
outlook, which is reflected in both the upward revision to the growth path and the upward shift in
the balance of risks surrounding that path. Accordingly, we are no longer concerned about
deflation risks, which is why the reference to "act[ing] by using all the instruments available within
its mandate" was removed from the introductory statement. We no longer perceive a sense of
urgency to take further measures to combat adverse tail risks.
Nevertheless, in important ways our assessment remains unchanged. The economic risks,
though becoming less pronounced, remain tilted to the downside. And crucially, we have not yet
seen the firming recovery translate into a durable strengthening of inflation dynamics. Headline
inflation has increased, but largely on account of rising energy and food price inflation. Underlying
inflation pressures continue to remain subdued.
Our latest projections foresee inflation moving towards levels below, but close to, 2% over the
forecast horizon. Given the softness of underlying inflation, however, we cannot yet be sufficiently
confident that inflation will converge to levels consistent with our aim in a durable manner.
Inflation dynamics also remain reliant on the present, very substantial degree of monetary
accommodation, so they have not yet become self-sustained.
Against this background, the Governing Council reaffirmed its monetary policy stance, including
its forward guidance, in order to secure a sustained convergence in inflation towards our aim and
insure the recovery against the downside risks that still persist.