Peter Praet: Monetary policy in the context of balance sheet adjustments
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the Peterson Institute for International Economics, Washington DC, 22 May 2013.
* * *
I would like to thank Fédéric Holm-Hadulla and Massimo Rostagno for their contribution to preparing this speech.
Slides to the presentation can be found on the ECB's website.
Ladies and Gentlemen,
It is a great pleasure to speak to you today.
I would like to use this opportunity to discuss the ECB's monetary policy response to the
profound balance sheet adjustments currently taking place in the euro area.
Like in most developed economies, different sectors in different euro area countries have
entered into a deep deleveraging phase over recent years. A deleveraging phase follows a
credit boom gone into reverse: financial and non-financial firms shift their focus from
exploiting business opportunities to reducing risk exposure. Likewise, households seek to
clean their balance sheets from sources of vulnerability. Deleveraging presents central banks
with a delicate balancing act:
• It is a necessary and healthy reversal of past borrowing excesses. To that extent,
policy-makers should not stand in the way of "the invisible hand" (or perhaps, more
fittingly, "the invisible scissors") that trims balance sheets to sustainable proportions.
Unless the oppressive load of debt and capital overhangs is run down, the
misallocation of resources will constrain future opportunities. Solving a stock
problem today means resolving a chronic flow problem - anaemic income,
production and expenditure - for years to come.
•
At the same time, deleveraging carries risks if it is abrupt and disorderly.
Accelerated deleveraging by the financial industry brings with itself the threat of a
protracted suspension in financial intermediation. In a worst-case scenario, this can
lead to a fully-fledged financial meltdown. But, even if the meltdown scenario is
avoided, lack of finance adds to the economic headwinds by suppressing
investment. Sluggish investment, in turn, lowers income and prices, thus reinforcing
deleveraging pressures.
If this cycle of adverse externalities across sectors sets in, the ensuing deleveraging spiral
becomes a matter of public policy concern. It becomes a monetary policy concern to the
extent that it impairs the transmission of monetary policy signals to the real economy.
Central banks thus have a role to play in managing the deleveraging process, knowing that
crisis management has to complement, but should not obstruct, crisis resolution. They must
ensure that the economy does not enter into a downward spiral that would be inconsistent
with price stability.
But how can they succeed in this task without delaying structural repair? Do they have the
tools? If not, who can complete the policy framework? How can central banks align
shortterm crisis fighting efforts with their longer-term monetary policy strategies and mandates?
These are the questions that currently preoccupy central bankers around the globe, albeit to
different degrees and a varying sense of urgency. Let me frame these preoccupations today
with a euro area perspective. I will proceed in three steps:
• First, I will highlight the key challenges that central banks and policy makers face
when formulating their crisis response in the context of acute deleveraging
pressures.
•
Second, I will explain how the ECB has responded to these challenges and how
other policy domains have to contribute to tackling the deleveraging risks.
•
Finally, I will reflect on how the institutional framework of Economic and Monetary
Union (EMU) in Europe directs, complements and bolsters the ECB's crisis
response.
1. Ongoing balance sheet adjustments
Leverage cycles are difficult for central banks to tame, essentially for two reasons: first, they
are difficult to empirically identify, measure and describe with available analytical tools,
especially in real-time; second, even if analysts found ways to spot them with reasonable
accuracy in real-time, central banks and other macro-policy authorities may need to apply an
atypical degree of inventiveness to control the potential macroeconomic fall-out, when
leveraging finally goes into reverse.
Let me explain these two issues one-by-one.
1.1 Identification of the leveraging cycles
First of all, it is financial cycles, i.e. long and deep swings in asset values, that policy
per
authorities essentially care about. They do not necessarily care about leveraging se.
Leveraging cycles become the problem because, as has long been recognised, swings in
asset prices do not pose serious threats to the economy, unless they are facilitated and
compounded by trends in debt. This combination and mutual feed-backs between trends in
asset values and sustained movements in leverage are what James Tobin defined the
"Achilles heel of capitalism". So, let me concentrate on leveraging cycles, knowing that it is in
fact this mutually reinforcing process between debt and financial values that we fear most.
Leveraging and deleveraging cycles are difficult to interpret and turning points hard to
identify. Is a debt hump that leads to a surge in the average loan-to-income ratio justified by
an increase in future incomes? Or is it a reflection of imprudent behaviour? Or is it a gamble
for survival? It is difficult for a central bank to pass a clear-cut judgement in real time. This
problem is not unlike the well-known identification problem for business cycles, but it applies
to deleveraging to an even greater extent.
Traditionally, and until very recently, published empirical analysis has not supported policy
practitioners too generously in their effort to divine the direction of financial trends. The crisis
has of course propelled the study of the leverage cycles to the forefront of research. But
statistical inference is imperfect when it comes to real-time identification of underlying
tendencies which take a long time to develop and emerge to observation.
For example, Drehmann, Borio and Tsatsaronis (2012) at the BIS have used a methodology
to visually chart how leveraging and deleveraging waves interact with the business cycle,
occasionally coming to a coincidental climax that makes the successive turning of both
waves very deep and prolonged.1 That methodology identifies also points which - ex post -
you would understand as changes in direction.
But the usual problem that we encounter in identifying business recoveries and recessions
when they start is amplified here by a factor of 2. In order to identify business cycles you
need statistic filters with frequencies from 1 to 8 years. To do the same for leveraging cycles
- at least in the sample of advanced industrial countries that the BIS study surveys - you
need a 16 year frequency. This obviously calls for long spells of data. And, the two-sided
structure of the filter stretches data requirements even further - into the unknown future! So,
the approach - interesting and informative as it is for retrospective inference - is not yet fully
applicable for policy purposes.
Other detectors of the state of leveraging and the risks originating from leveraging cycles
exist, some of them using combinations of warning indicators. For instance, Alessi and
Detken (2011) use indicators, inter alia, of private credit to parse out costly boom-bust
episodes from garden-variety changes in asset prices in real-time.2 Claessens, Kose and
Terrones (2011) characterise the interplay of cycles between different market segments,
including credit, housing and equity markets, and between countries.3 Also exploiting
crosscorrelations between various market segments, Holló, Lo Duca and Kremer (2012) develop a
composite indicator to measure systemic stress in the financial system.4
Reading this analysis, we know that the credit-intensity of the expansion phase is closely
associated with the severity of the recession phase. A stronger increase in financial leverage,
measured by the rate of change of bank credit relative to GDP in the prior boom, tends to
correlate with a deeper subsequent downturn. We know that credit changes its nature as the
leveraging cycle progresses. It is a facilitating factor in the run-up stage of the boom, when
agents are intent on maximising return opportunities. And it turns into a forcing factor when
the first - and almost exclusive - business priority for over-indebted agents becomes
reducing indebtedness. As Jordà, Schularik and Taylor (2011) report on the title of their
paper on credit cycles, "credit bites back".5
These analytical efforts, along with the other work currently conducted in this vibrant strand
of literature, clearly enhance our appreciation of risks. At the same time, further research will
be necessary to operationalize these findings in a way that can reliably guide policy-makers
in a real-time. For example, more analysis is needed on how different policy action would
feed back into the different indicators of financial market risk.
1.2 The many facets of liquidity and their interaction with leverage cycles
As I mentioned earlier, the second reason for macroeconomic authorities to be wary of
leveraging cycles is that their reversal poses policy challenges of unconventional intensity.
The reason is that deleveraging cycles interact with liquidity cycles in complicated and
sometimes impenetrable ways.
Before explaining these interactions, let me introduce some additional taxonomy.
What is a liquidity cycle? In fact, there are several important concepts and definitions of
liquidity. One crucial distinction refers to asset market versus funding liquidity:
•
Asset market liquidity measures the ease with which an asset is traded at any time
with little price concessions. It reflects the cost per unit of time of converting a
financial asset into money. When market liquidity collapses - in a liquidity crisis -
assets that had enjoyed high tradability become illiquid in the sense that trimming
exposures is possible only at a large penalty.
•
Funding liquidity - an alternative, if complementary concept - measures the ability
of a financial institution which engages in maturity transformation to obtain constant
funding for its long-term assets.
This distinction is at the centre of Brunnermeier's and Pedersen's (2009) analysis on the
interplay between leverage and liquidity cycles. Here, the authors show the reinforcing nature
of funding shocks and leverage in shadow-banking intermediation.6 Here, a funding shock
materialises in the form of higher haircuts in the repo market, where intermediaries operating
in the shadow-banking market - say, a hedge fund - finance the acquisition of assets. For a
hedge fund that is financing asset holdings in the repo market, mechanically, a rise in
haircuts that is not offset by either slack in the existing equity capital base or an infusion of
fresh equity capital will cause the fund to liquidate assets. A collective trend to liquidate
assets cannot happen unless prices drop. But a fall-off in asset prices devalues the collateral
that is pledged in parallel leveraged operations and more margin calls are triggered. So, the
funding liquidity asset market liquidity
original shock turns into an shock. The latter then
retroacts into a more severe and widespread funding liquidity problem. See also how these
cycles get intertwined with leverage decisions and can trigger rapid deleveraging in the
shadow banking industry: for hedge funds or broker-dealer businesses, which typically
finance an asset acquisition in the repo market, the maximum leverage for that specific
operation is given by the inverse of the haircut which is applied on the value of collateral by
the funding entity in the repo transaction. As the haircut increases in the adverse liquidity
conditions that I have described, the leveraging potential of the shadow-bank plunges almost
mechanically.
These notions of liquidity cycles - and their interactions with leverage - are now almost old
hat for macroeconomists.
But there is another representation of a liquidity cycle that has escaped much academic
investigation. This representation distinguishes different types of liquidity depending on its
issuer:
•
Outside liquidity comprises currency or, more generally, central bank overnight
liabilities. These liabilities are what we typically understand as "money" in the
narrowest sense of the word. In our modern fiat-money systems, this form of money
is backed by a legal and social promise to essentially preserve its purchasing power
and transaction services over time.
•
Inside liquidity is a much broader object, including short-dated money-like liabilities
that are issued by the private entities and thus backed by private credit. They would
cancel out if all the claims held by banks on private creditors were to be settled. So,
it is one form of currency that is created - and can be destroyed - within the private
economy.
On the basis of this distinction, we can explain another type of liquidity cycle, which I will
refer to as the "outside-inside" liquidity cycle. This cycle reflects the alternating phases and
sometimes wild swings characterising banks' demand for precautionary buffers of outside
money from the central bank.
Again, the alternating phases of this type of cycle come to interplay with the underlying
deleveraging course. And they do so in a way that can strongly complicate policy.
1.3 The scope and limits for central banks to control leveraging cycles
Let me describe how these complications played out in the current crisis.
In the early days of the financial crisis, banks were saddled with a legacy of illiquid and
unprofitable assets, which they were forced to refinance. As the markets had withdrawn
credit, and the price of those assets in the market had plunged, they came to central banks
for refinancing. This produced a huge expansion in central bank liquidity which banks were
drawing into the system as central bank credit was replacing private finance. Because the
network of interbank trading had seized up almost entirely, banks with excess deposits were
unwilling to lend to banks with a structural funding shortfall. The trading gap was filled by the
ECB, which was asked to absorb the liquidity supplied by the former and give more credit to
the latter.
In other words, outside liquidity substituted for an erosion of inside liquidity.
As a consequence, in the ten months following the collapse of Lehman Brothers, outstanding
ECB credit to euro area banks rose by around 90%, while the outstanding volumes of euro
liquidity deposited overnight with the ECB went from virtually zero to three-digit billion figures.
By any account - whether measured on the ECB's assets side or on its liabilities side - the
demand for central bank liquidity had reached unprecedented peaks. That was the first stage
of a very severe outside-inside liquidity cycle, which central banks - everywhere - had to
accommodate. Note that, at that very early stage, the de-leveraging cycle had hardly started.
For instance, in the nine months after Lehman total assets of the euro area banking system
fell by around one percentage point.7 So, banks needed an outsized volume of liquidity at
hand in order to be able to refinance a balance sheet that had remained more or less
constant at around its pre-crisis size.
The early steps of the outside-inside liquidity cycle - the phase in which banks' demand for
outside liquidity surges - were effectively cushioned. Successive rate cuts since the onset of
the crisis have brought our main policy rates to historical lows. Our standard liquidity facilities
have been expanded in maturity and used to channel unlimited liquidity at a certain price to
provide funding reassurance to euro area banks. For example, in a bold step, the maturity of
our lending operations was extended to three years. In two long-term refinancing operations
which we launched at the end of 2011 and early 2012 banks absorbed a net volume of EUR
500 billion in additional liquidity. The replacement of central bank liquidity for failing market
credit has averted devastating prospects of a fully-fledged financial depression. Our
measures were instrumental in cushioning the value-destroying deleveraging forces that
could have developed into a deflationary spiral.
But, with a certain lag, the de-leveraging cycle started at some point to run its own course.
Banks began shedding assets - either because those illiquid, unprofitable exposures had run
off in the meantime, or because they had been written down, or because other, more
profitable, assets had been sold at a profit, to make up for losses. Or simply because banks
had realised that their old business model was unsustainable and the size of their activities
had to be reduced discretely.
Whatever the reason behind a down-sizing of banks' balance sheets, when they embarked
on large scale deleveraging, their liquidity needs declined. So, they started shedding central
bank liquidity as well. The liquidity surge is being gradually unwound, bringing the
outsideinside liquidity cycle to a mature stage. One manifestation of this unwinding of exceptional
liquidity demand is the early repayment of the ECB's three-year refinancing operations that
have amounted to more than €280bn to date.
The voluntary reimbursement of liquidity can be interpreted as a good sign, as it largely
reflects normalisation in banks' funding conditions. When we explore the determinants of
reimbursements, we see that it comes together with a measurable return of retail lending to
banks that had long suffered loss of funding, and, for some of them, even a timid resurgence
of wholesale borrowing activity. So, the shrinking of liquidity demand has a positive
connotation. But the potentially difficult aspect of this process for a central bank is that the
demand for central bank liquidity and the underlying de-leveraging process are not
synchronised. In fact, the demand for central bank liquidity (and the sensitivity of private
sector lending decisions to policy signals) may drop just when the de-leveraging cycle starts
producing its effects on the economy.
This intersection between the two cycles can be risky for the economy. Asset shedding can
be as extreme and divorced from fundamentals as the build-up of debt that had preceded
- and largely caused - the crisis. So, as I said at the start, the central bank may have to be
vigilant that the pace of asset reduction by banks is commensurate with an evolution of
income, activity and employment that does not create downside risks to price stability. But
this policy strategy may be difficult to pursue in a situation in which banks' propensity to
absorb central bank liquidity is muted.
2. The short-term crisis response
Does this mean that, in the dark-grey zone of intersection between the two cycles, policy is
left impotent?
The answer is: absolutely no. But the complexities and risks that I tried to describe require a
well-designed, multidimensional and consistent policy response.
First and foremost, what's needed is a thorough and transparent identification of risks on
bank balance sheets and a robust reconstruction of equity. This is not limited to banks -
households' and firms' own capital should be reinforced too, if they are to withstand future
shocks and restart planning growth. But it particularly applies to banks.
This call for balance sheet repair may sound like the ceterum censeo of anyone commenting
on the financial sector these days. But we should not forget the successful practical
precedents to underpin these calls.
For example, the Nordic banking crisis in the 1990s provides a case study of how decisive
and well-targeted crisis management can mitigate and shorten the damaging effects of
deleveraging stress.8 With an external crisis constraining the room for manoeuvre for
monetary policy and fiscal policy alike, the authorities addressed balance sheet repair
headon. They first forced a comprehensive recognition of losses on their domestic banking
systems. Then, they recapitalised institutions subject to stringent stress tests, sorting
institutions based on viability, and dealing with bad assets through disposal. And, finally, they
ensured a reduction in excess capacity in the financial system.
More recently, we saw important financial reform put into practice in some euro area
countries. Most notably, one year ago, the Spanish banking system was ostracised in the
inter-bank market and deserted by capital investors and depositors. Adverse selection was in
full display: uncertainty about the location and extent of exposures to the real estate sector
was heavily weighing on the stability and viability of the Spanish banks. The authorities,
within the new European Stability Mechanism framework for financial stability assistance,
took an approach in many respects similar to that followed 15 years before by Sweden. First,
they embarked on a serious mapping of the problem through a detailed, state-of-the-art
stress testing exercise. Second came a surgical separation and removal of assets of dubious
quality for those banks which had detected capital shortfalls and proved most vulnerable to
future shocks. Third, loss recognition and recapitalisation took place by activating the
European Stability Mechanism. Fourth, they put in place a comprehensive and innovative
regulatory reform which empowers authorities to take timely and decisive action for bank
recovery and resolution.
It is too early to declare victory. And many challenges still loom ahead. But today, many of
the banks that had suffered from a generalised loss of confidence have returned to the
market and see their funding gaps decline rapidly. In fact, in a sign of normalisation, some of
them have participated en force in the early repayment of the long-term refinancing that they
had requested 18 months ago in very tense liquidity conditions.
Obviously many of the measures involved in these policy efforts go well beyond the tasks
and powers of the ECB as a monetary policy-maker. In fact, many of the necessary steps will
need to be taken in other policy domains.
But the ECB can flank and support some of these steps, in particular, by forcefully
responding to price stability risks. To that effect, monetary policy will continue employing its
existing instruments and if necessary to expand its instrument set within the safeguards
established by its strategy.
3. The long-term ECB strategy
To be successful in delivering on its mandate in troubled waters, the ECB's strategy has to
combine two main attributes: it must be sufficiently flexible to adjust its policy conduct to the
binding
specific challenges at hand. And it must be sufficiently to anchor expectations and
build central bank credibility with market participants and the general public.
The flexibility of the ECB's monetary policy framework derives from three features:
The first is a definition of price stability, which is formulated in terms of a range, with an
explicit focal point for policy identified within that range. The range is defined as comprising
rates of inflation which do not distort economic decisions: positive inflation rates of no more
than two per cent. Within that range the ECB's Governing Council aims at attaining a level of
inflation over the medium term - the focal point of policy - which is "close to" the upper
ceiling of two per cent. The buffer interval between our focal point and the floor of the range
serves as a safeguard against deflation risks for the euro area as a whole. It also allows
monetary policy to account for inflation differentials across individual euro area countries. In
the presence of large and persistent dispersion in inflation rates across countries, an inflation
objective too close to zero would imply that countries with below average inflation have to
systematically operate under deflation - even if average inflation rates for the euro area were
in positive territory.
The second element is that our definition of price stability applies over the medium-term. In
other words, the policy-relevant horizon is a choice variable. But the choice of the extension
of the horizon is conditional on the nature of the shocks shaping the inflation and economic
outlook.
Let me explain how that flexibility guides our policy response to different shocks in practice.
If the shock that moves inflation at a certain point in time comes from demand forces, our
strategy postulates a monetary policy response that brings inflation back, within the range of
values that define price stability, to its focal point over a relatively short horizon. "Short"
means here: in line with the minimum time period that monetary policy actions typically take
to transmit their impulse to the real economy. This way, inflation expectations are kept
anchored and a stable path of the economy toward the new equilibrium is ensured.
If the underlying shocks are on the supply side, there might not be an immediate cause for
action. The medium term in this case may be stretched beyond the canonical minimum
transmission lag and thus provides for an in-built mechanism to see through temporary
supply shocks. Crucially, this applies only to the extent that you are reassured that long-term
inflation expectations remain well anchored. Therefore, once it transpires that the supply
shock is likely to be of a permanent nature because it is passed through to price and wage
setting behaviour, the ECB would act.9 But the flexibility in the policy-relevant time horizon
grants it sufficient time to identify whether the shock is transitory or permanent before
changing course. This, in turn, allows for a steady-hand approach to our monetary policy that
avoids undue policy-induced economic fluctuations.
Third, adding to the flexibility deriving from the price stability definition and the variable policy
horizon, the ECB has large scope in adopting further tailored measures to address specific
market impairments. In this context, deliberations on enhancing the provision of credit in the
economy take particular prominence in our current strategy process.
So, let me move to the issue of credibility.
The attribute of credibility is even more important than flexibility. In fact, credibility is a
precondition for a central bank to be able to act flexibly without unhinging market
expectations. The extent and success of central bank intervention to stabilise the economy
hinges on the credibility of their monetary policy framework. Higher-order constraints - an
institutional discipline - make the conduct of policy - a lower-order activity - both more
flexible and effective.
This is due to the following reasons.
If market participants are confident that the central bank - in line with its mandate - is
determined to offset price pressures, they will immediately factor this into their economic
decisions. Hence, the mere prospects of future central bank accommodation will induce
consumers and firms to shift consumption and investment decisions across time. For
instance, in a slump consumers and firms anticipate additional accommodation in the future,
thus frontloading consumption and investment. Vice versa, in an overheating phase,
consumers and firms restrain current spending to prepare for a more constrained monetary
policy environment in the future.
In both cases, the reliable anticipation of the future central bank response mitigates the
fluctuations. In other words, central bank credibility acts as an automatic stabiliser by
inducing inter-temporal substitution in economic activity. All that's needed is a clear and
credible commitment by the central bank to a certain course of action.
But how can we establish such commitment? The answer is: through an institutional
framework that makes the central bank predictable and that protects it from the temptation to
leave the path prescribed by its objective.
This rationale lies at the heart of forceful safeguards to the ECB's monetary policy
independence. These safeguards ensure that our decisions are not contaminated by
considerations other than those deriving from our price stability objective.
This is the backdrop, against which I interpret the monetary financing prohibition, which bans
central bank direct lending to fiscal authorities: engaging in such direct lending to
governments jeopardises a central bank's capacity to act independently and with the sole
focus on monetary policy objectives; the loss of independence and focus, in turn, jeopardises
central bank credibility; and the loss of central bank credibility jeopardises macroeconomic
performance as it contravenes automatic stabilisation induced by private sector expectations.
The monetary financing prohibition in the ECB's legal framework plays an essential role in
fostering central bank instrument independence. It is not simply a constraint on what the ECB
can do. It is also a safeguard that reinforces our action and protects our capability to act in
pursuit of our objective, when such action becomes necessary.
It is a catalyst of credibility. And building on the credibility arising from independence, the
ECB is therefore well-placed to forcefully and flexibly confront any risks to the economy
without unanchoring expectations.
It is within the frame laid down by the Treaty that we can confidently say that the ECB will act
decisively to preserve price stability and - subject to that condition - minimise wasteful
fluctuations in activity.

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