Mario Draghi: How central banks meet the challenge of low inflation
Text of the Marjolin lecture delivered by Mr Mario Draghi, President of the European Central
Bank, at the SUERF-Deutsche Bundesbank-IMFS Conference on "SSM at 1", Frankfurt am
Main, 4 February 2016.
* * *
Robert Marjolin was a pivotal figure in the birth of Economic and Monetary Union. When the
Treaty of Rome was signed in 1956, the aims of European Economic Community were
largely limited to creating a customs union and a common agricultural market. Neither was
perceived to require monetary integration. It was only with the launch of the so-called
"Marjolin Memorandum" in 1962 that the recognition surfaced that a single market and a
single money were linked and that a serious discussion on European monetary integration
began.
Today, more than 60 years on, monetary integration in the euro area is both complete and
secure. But monetary policy faces many challenges. Those challenges have not changed our
mandate. But they have altered the way in which we deliver it.
To understand how we have responded to those challenges, it is useful to distinguish
between two types.
First, there are challenges that are common to all central banks in advanced economies,
which are linked to a global low inflation environment.
Second, there are challenges that are special to us in the euro area, which are linked to our
particular institutional context.
What is common for all
The most fundamental question facing all major central banks today is this: can our price
stability mandates still be delivered? Across advanced economies inflation is low, and has
been low for some time. And in several of those economies, long-term inflation expectations,
based on market prices, remain below our numerical definitions of price stability. That has
led some to question whether it makes sense for central banks to pursue expansionary
policies to meet their inflation objectives. Are they fighting a futile battle against forces
beyond their control?
There are essentially three lines of argument in favour of monetary policy not reacting to the
low inflation we see today.
The causes of too low inflation
The first line of argument is that low inflation is increasingly being caused by structural
factors in the global economy that cannot be addressed through domestic monetary stimulus.
As a result, it is said, previous notions of what we considered low and stable inflation -
inflation rates around 2% - are no longer realistic. Central banks should adjust their
objectives downwards accordingly.
If this argument were accurate, it would constitute a very fundamental criticism of central
banks' mandates. After all, the decision to grant central banks price stability objectives, and
to give them independence to deliver those objectives, was based on the understanding that
inflation is always, ultimately, a monetary phenomenon. It could thus always be controlled in
the medium-term by a committed monetary authority.
So is it true that structural changes we see today are having a permanent impact on
longterm inflation levels?
One such change that is often mentioned in this respect is demographic change. This
certainly heralds important economic shifts, but its impact on inflation is ex ante unclear. It
might put downward pressure on prices if aggregate demand falls more than aggregate
supply. But it might equally create upward price pressures: according to the life-cycle
hypothesis, an ageing population implies that the elderly eventually dissave and consume
more.1
Which effect dominates will depend on a range of factors. In any event, it seems unlikely that
demography can explain why inflation is low today across advanced economies that have
very different demographic profiles.
Moreover, even if ageing were to lead to a period of disinflation, for example through savings
and investment imbalances, there is no reason why that should imply a permanently lower
inflation rate. An excess of savings would simply mean that the equilibrium real interest rate
required to deliver price stability would be lower, and the central bank would have to factor
that into its monetary policy. Put another way, the effects of ageing would call for us to adjust
our instruments, but not our objectives.
Other structural shifts are also seen by some as having a long-term impact on inflation. One
is the fact that the long-term cycle in commodity prices is now going into reverse. Another is
technological change, especially e-commerce, which increases price transparency and
intensifies competition between suppliers and retailers, which may keep prices low. A third is
globalisation, which may increase the importance of global prices relative to domestic prices,
making it harder for advanced economies to avoid importing disinflation from abroad.2
Each of these changes might have an influence on the inflation rate. We cannot deny that.
But there is nothing about them which suggests these effects are permanent. For example,
permanent changes in the supply of energy are likely to have a permanent effect on the price
level. But at some point energy price disinflation must reverse, if only due to base effects.
Similarly, the price-containing impact of e-commerce, if any, will last only until the diffusion of
e-commerce has stabilised. And lower imported inflation thanks to globalisation should
eventually lead to higher prices elsewhere, as disposable income increases and the levels of
wages and other costs equalise across countries.
So there is no reason why any of these structural changes should make our current price
stability objectives unobtainable. They may create global disinflationary forces, but those
forces are transitory in nature. What can affect our objective, however, is if those forces have
a persistent impact on inflation - which is to say, if they become embedded in inflation
dynamics and inflation expectations. But that is not a structural issue; it is about the
credibility of monetary policy in anchoring inflation expectations.
This brings me to the second line of argument against active monetary policy.
The response to too low inflation
There are some who argue that, so long as we are experiencing mainly positive global
supply shocks, there is no need for central banks to be overly responsive. We can simply
redefine the medium-term horizon over which price stability is maintained and "wait it out"
until inflation returns to our objective. Indeed, the reason central banks do not define the
medium-term as a period of calendar time is that the horizon for action depends on the
nature of the shock.
This viewpoint is correct, as far as it goes. Central banks do typically refrain from reacting to
supply shocks that have opposing effects on output and inflation, so as not to overreact and
reinforce the effect on growth, in either direction. And that might even be the case when
faced with a succession of supply shocks, such as the steep falls in oil prices we have
experienced recently. Each shock should in principle have a short duration and should not
have a persistent effect on inflation.
However, since there is always a backward-looking component in inflation developments, the
longer inflation stays too low, the greater the risk that inflation does not return automatically
to target. Specifically, if agents start to look at the track record of recent inflation, rather than
the inflation objective, it affects their benchmarks for wage and price setting decisions. What
happens then is that low inflation feeds into inflation expectations and creates second-round
effects.
In that situation, even what began as a positive supply shock can turn into a negative
demand shock. As inflation expectations fall, it pushes up real interest rates, producing an
unwarranted monetary tightening. And the unexpected low inflation raises real debt burdens,
which has a negative effect on aggregate demand due to the different propensities to
consume and invest of borrowers and lenders. Output and inflation, then move again in the
same direction - but this time downwards.
For that reason, in a context of prolonged low inflation, monetary policy cannot be relaxed
about a succession of supply shocks. Adopting a wait-and-see attitude and extending the
policy horizon brings with it risks: namely a lasting de-anchoring of expectations leading to
persistently weaker inflation. And if that were to happen, we would need a much more
accommodative monetary policy to reverse it. Seen from that perspective, the risks of acting
too late outweigh the risks of acting too early.
In sum, even when faced with protracted global shocks, it is still monetary policy that
determines medium-term price stability. If we do not "surrender" to low inflation - and we
certainly do not - in the steady state it will return to levels consistent with our objective. If on
the other hand we capitulate to "inexorable disinflationary forces", or invoke long periods of
transition for inflation to come down, we will in fact only perpetuate disinflation.
This is the clear lesson of monetary history, especially the experience of the 1970s. At that
time, many policymakers argued that persistently high inflation was structural and central
bankers could do little to reduce it. For example, in May 1971, when Arthur Burns was
Chairman, the official staff presentation to the FOMC declared - like some of our critics today
- that "the question is whether monetary policy could or should do anything to combat a
persisting residual rate of inflation ... the answer, I think, is negative ... it seems to me that
we should regard continuing cost increases as a structural problem not amenable to
macroeconomic measures".3
Similarly, Fed Chairman William Miller observed in his first FOMC meeting in March 1978
that, "inflation is going to be left to the Federal Reserve and that's going to be bad news. An
effective program to reduce the rate of inflation has to extend beyond monetary policy and
needs to be complemented by programs designed to enhance competition and to correct
structural problems".4 It was only when Paul Volcker arrived as Chairman in 1979 and
shortened the policy horizon that the Fed took ownership for controlling inflation. Inflation,
which peaked at around 15% in March 1980, fell below 3% by 1983.
Some argue that today the situation is different; that whereas Volcker could raise rates to
20% to tame inflation, central banks fighting disinflation are inhibited by the lower bound on
interest rates. The Japanese experience after the bursting of the housing bubble in early
1990s is often presented as evidence.
But the Japanese case in fact only reinforces the importance of full commitment from
policymakers. As long as the commitment of the Bank of Japan to a low positive inflation
number was not clear, actual inflation and inflation expectations stayed in deflationary zone.
Since the Bank of Japan has signaled its commitment to reach 2% inflation, however, core
inflation has risen from less than -0.5% in 2012 to close to 1% today. This is still short of the
2% objective, to be sure, but downward price shocks are also hitting Japan like all other
advanced economies.
We now have plenty of evidence that, if we have the will to meet our objective, we have the
instruments. As the ECB and others have demonstrated, the lower bound for policy rates,
wherever it might be, is not at zero. And we have also shown how non-standard tools can be
used to deliver monetary stimulus even without altering much the overnight rate, and
produce equivalent effects. For example, the non-standard measures the ECB has taken
since summer 2014 have produced a pass-through equivalent to a 100 basis point rate cut in
"normal" conditions.
So there is no reason for central banks to resign their mandates simply because we are all
being affected by global disinflation. In fact, if all central banks submit to that logic then it
becomes self-fulfilling. If, on the other hand, we all act to deliver our mandates, then global
disinflationary forces can eventually be tamed.
The costs of fighting too low inflation
Still, there are some that argue that even if central banks can lean against global
disinflationary forces, in doing so they do more harm than good. In particular, expansionary
monetary policies at home lead to the accumulation of excessive foreign currency debt or
asset price bubbles abroad, especially in emerging markets. And when these financial
imbalances eventually unwind, it weakens global growth and only adds to global disinflation.
This is the third line of argument.
But I ask, what would be the alternative? Would it help emerging markets if advanced
economy central banks failed on their mandates? Would that be more likely to contribute to
global growth? Clearly, the answer is no. The stability of large economies is vital to their
trading partners and to the global economy, and diverting monetary policy away from that
aim when our economies are still fragile would not be in their interest. In the euro area that is
especially true for our neighbouring economies, which export around 50% of their goods and
services to the euro area.
In fact, when central banks have pursued the alternative course - i.e. an unduly tight
monetary policy in a nascent recovery - the track record has not been encouraging.
Famously, the Fed began raising reserve requirements in 1936-37, partially due to fear of a
renewed stock bubble, but had to reverse course the next year as the economy fell back into
recession. That has also been the experience of some central banks in recent years: raising
rates to offset financial stability risks has undermined the primary mandate, and ultimately
required rates to stay lower for longer.
This suggests that the so-called "assignment problem" between monetary policy and
financial stability at the domestic level should also apply at the global level. Monetary policy
should not try to balance opposing objectives: it is optimal for all parties if it delivers its
mandate. And if that creates financial stability concerns, they need to be addressed by other
policies more suited to the task. And in fact there are several policy levers available.
Countries can improve their financial regulation and supervision to make their financial
systems more resilient to external shocks. They can adjust their fiscal policies. They can
adopt macro-prudential measures. The evidence suggests that such policies can be
effective: emerging market countries differ significantly in their sensitivity to global financial
developments on account of their policy frameworks.5 We also have some anecdotal
evidence that macro-prudential measures are working in Asian economies, especially in
cooling off the real estate sector.
Finally, these general considerations aside, it is worth questioning whether such arguments
about monetary policy spillovers actually hold for the euro area. For example, if we look at
spillovers into asset prices, there is no evidence that the announcement of the APP induced
a surge in portfolio flows into emerging market economies. In fact, empirical evidence
suggests that global investors rebalanced out of emerging market bond and equity markets
into bond markets of advanced economies, in particular in the euro area, in response to the
APP launch.6
And if we look at foreign currency debt, while low euro area interest rates have led to
significant increases in euro-denominated debt security issuance outside the euro area in the
past two years, issues in euro still only account for about one-quarter of international bond
issuance, while issues in dollar account for two-thirds. What is more, recent foreign bond
issuance in euro is dominated by investment grade US corporates, and among the emerging
markets, highly-rated issuers. The evidence of unhealthy spillovers and financial stability
risks therefore seems limited.
What is special to us
So even in the face of common global shocks, central banks have the ability to deliver their
mandates. But in the euro area, that requires a different monetary policy response than for
others. That is because we also face a second set of challenges that are largely specific to
us. They result from our institutional structure: conducting monetary policy in a segmented
banking and capital market, and without a single area-wide fiscal authority as a counterpart.
There are two types of challenges in particular that emerge from this.
Transmitting the stance
The first relates to monetary policy transmission. Many central banks have faced
impairments in the transmission process during the crisis - that is why, for example, the Fed
began intervening in markets for mortgage-backed securities, or the Bank of England
launched its funding-for-lending programme. But it is clear that those impairments have been
more severe in the euro area. And moreover, they have had a distinct regional dimension
that was not visible in other jurisdictions.
Our specific challenge arises from having an incomplete banking and capital market, which
leads to lower sharing of risks. Relative to a fully integrated market, portfolios of private
assets in the euro area are less geographically diversified, concentrating the effect of local
economic slumps. Credit markets are less integrated, making it harder for agents to borrow
from other parts of the union to smooth out such shocks. And institutions for cross-border
public risk-sharing are less developed, placing the full burden of dealing with the after-effects
on individual sovereigns.
This has two consequences for monetary transmission. First, it means that some of the main
transmission channels - namely the bank lending channel and the balance sheet channel -
are more likely to be disrupted in the event of major shocks. And second, since private risk
and sovereign risk are linked at the national level, it means that financial fragmentation takes
place along national lines. That hampers the traction of monetary policy in the regions where
monetary stimulus is most needed.
None of this means we cannot fulfill our mandate. But it does mean we have to design our
instruments to compensate for it. That is why, for large parts of the crisis, our measures were
also geared towards addressing impairments in the smooth transmission of our policy.
Early on in the crisis, this meant substituting for the drying up of the interbank market,
including at longer maturities, to ensure the flow of cross-border liquidity. Later, we took out
unwarranted redenomination risks from sovereign debt markets, helping attenuate the
banksovereign nexus. More recently, we have launched a credit easing package which aims,
among other things, to ensure that bank deleveraging does not produce excessive dispersion
in lending rates across countries. The evidence suggests that each of these measures has
been successful.7
Still, it is clear that fragmentation risks can only be definitively removed by addressing their
institutional drivers. That is why the creation of Banking Union, which is the topic of our
conference today, was such a fundamental addition to monetary union.
The Single Supervisory Mechanism provides a framework for a more integrated banking
market, which would be less likely to fragment under stress. The Single Resolution
Mechanism facilitates greater risk-sharing across borders. And the commitment to develop a
Capital Markets Union is the first step towards greater geographical diversification, especially
in cross-border holdings of equity.
What is still missing, however, is agreement on the third leg of Banking Union - deposit
insurance - which is an essential part of a genuinely single money. For this reason, the
Commission's proposal to establish a European Deposit Insurance Scheme is welcome. On
the one hand, it sets out the ambitious objective of establishing a truly European system of
depositors' protection. That will support the creation of an internal market for deposits in
which the fungibility of deposits is assured independently of jurisdictions, and trust in
deposits is equalised.
On the other, it is realistic in its design and provides a number of safeguards against moral
hazard, so that risk-sharing does not become risk-shedding. "Risk reduction" and
"risksharing" measures are two sides of the same coin and should be pursued in parallel: they
are both essential to protect the stability of the European banking sector and ensure a
homogenous transmission of our monetary policy.
Expanding the stance
The second, specific challenge we have faced in the euro area has come when we needed
to expand our monetary stance - specifically, when we shifted from interest rates as the
main instrument of monetary policy to asset purchases via the APP.
In part, large-scale asset purchases aim at reducing the risk-free rate by taking out duration
from the market for sovereign bonds. In the euro area, however, we do not have a single
risk-free rate since we do not have a single fiscal issuer that acts as a benchmark. And there
is no national market which could act as a substitute, not only due to volume constraints, but
also because no government security in the euro area is truly risk-free. The prohibition on
monetary financing means that every sovereign bond carries a degree of credit risk.
In this context, asset purchases of the size we deemed appropriate must inevitably be
implemented in multiple markets. And that means monetary policy operations may
unwittingly impact on credit allocation across regions and types of borrowers. That is not
unusual - all monetary policy has allocative consequences. Nor does it create a limit on us
fulfilling our mandate. But it does require that we aim to mitigate those consequences, under
the constraint that we achieve our price stability objective. That can be done in two ways.
The first is by designing our monetary policy instruments in a way that minimises distortions.
We did this under the APP by intervening mainly in the most "commoditised" asset classes,
i.e. the government bond markets in each country, and by spreading our interventions
proportionally across jurisdictions. That effectively constructs a diversified pan-euro area
portfolio.
Second, allocative effects can also be reduced by further integrating the markets in which we
intervene, in particular government bonds. To that end, a robust fiscal framework which is
enforced credibly would reduce the risk inherent in individual government bonds in the euro
area, which would in turn make the impact of interventions in different markets more
homogenous.
Still, there can be no doubt that if we needed to adopt a more expansionary policy, the risk of
side effects would not stand in our way. We always aim to limit the distortions caused by our
policy, but what comes first is the price stability objective. That is the implication of the
principle of monetary dominance, which is embedded in the Treaty and which lends
monetary policy its credibility.
Monetary dominance means that we can - indeed we should - acknowledge and draw
attention to all the consequences, intended or unintended, of our monetary policy operations.
But it also means that we should never fail to deliver on our mandate solely on account of
those consequences. Doing so would be tantamount to redrafting our mandate under the
law, something we are not at liberty to do.
Conclusion
Let me summarise.
There are forces in the global economy today that are conspiring to hold inflation down.
Those forces might cause inflation to return more slowly to our objective. But there is no
reason why they should lead to a permanently lower inflation rate.
What matters is that central banks act within their mandates to fulfill their mandates. In the
euro area, that might create different challenges than it does in other jurisdictions. But those
challenges can be mitigated. They do not justify inaction.