Benoît Coeuré: Where to exit to? Monetary policy implementation after
the crisis
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the 15th Geneva Conference on the World Economy: "Exit strategies: time to think about
them", Geneva, 3 May 2013.
* * *
I wish to thank Massimo Rostagno, Tobias Linzert and Arthur Saint-Guilhem for their contributions to these
remarks. I remain solely responsible for the opinions contains herein.
Ladies and Gentlemen,
It is a great pleasure to attend once again the Geneva Conference and discuss the important
issue of exit from non-conventional monetary policies. Let me start with an important word of
caution. We are still struggling with the euro area crisis. Yesterday's decisions by the
Governing Council of the ECB on reduction of the key interest rates, on modalities of liquidity
provision and on possible ways forward to enhance the availability of credit to the broad
economy should support prospects for a recovery later this year. But current underlying
economic conditions still imply that the monetary policy stance will remain accommodative
for as long as needed.
That said, exit from non-conventional policies will come one day, and lessons drawn from the
crisis times will help us chart out our path. The debate on exit has chiefly concentrated on
strategies: that is, on monetary policy reaction functions on the way out of these policies and
over the new steady state. But it is fair to say that - with only few exceptions - participants in
the debate have been less active in discussing the operating framework of monetary policy.
Here, a few interesting questions remain unanswered. Will central banks go back to their
precrisis operating framework once conditions return to normal? Or should some of the novel
instruments remain in their toolbox ready for use, or even as standing instruments replacing
old practices?
Let me start by mentioning the three main developments that, in my view, took place during
the crisis:
•
First, central banks collectively moved towards instruments that can effectively
disentangle interest rate decisions from decisions concerning the size of their
balance sheets. One can debate whether this constitutes genuine bifurcation of
instruments. And, with Tinbergen in mind, one could also conjecture that, in this
way, the traditional assignment of the interest rate instrument to the price stability
objective could be reinforced by an independent lever which, through its control over
the volumes of central bank credit, would independently promote stable financial
conditions. Here, other central banks had to innovate more than the ECB. The Fed,
for example, acquired the authority to pay interest on reserves and this placed a
floor - or, more precisely, a lower grey zone of values - on the level which the Fed
funds rate can take on in daily overnight trading. The ECB, by contrast, entered the
crisis with a corridor system and an elastic operating framework which did not need
much tweaking to offset shocks. But we did shift from a competitive auction system,
in which quantities are controlled by the central bank, to one in which we fix the
price and take the quantities as endogenous in liquidity-providing operations. And
this meant at some point that the overnight rate was left to drift down to the floor of
the corridor, where it still stands. This, in turn, implies that the overnight rate has
become more independent of the volume of excess liquidity.
• Second important development during the
crisis: central banks in a large part of the
world engaged in non-conventional measures aimed at absorbing liquidity risk and
duration risk from the market. Those central banks engaged in quantitative easing
have focused on duration risk and have targeted term premia. The ECB has
primarily concentrated on liquidity risk. As I said, we decided to fully accommodate
banks' demand for liquidity in an elastic manner. We also expanded the list of
eligible collateral, so that banks could more easily liquefy their balance sheets and
mobilise assets that had become scarcely tradable for liquidity purposes with us.
The ECB took care of duration risk (or in our case funding risk), indirectly, to the
extent that we replaced banks' intermediate-maturity wholesale market borrowing
with our longer-term refinancing operations. As a result, the duration risk vis-à-vis
banks that markets did not want to bear migrated, to a certain extent and
temporarily, to our balance sheet.
•
Finally, the third important development during the crisis was that central banks had
to substitute for the sudden disruption of interbank market activity and became de
facto the "money market intermediary" of last - and sometimes first - resort. For the
ECB this was facilitated by the broad range of counterparties accepted in monetary
policy operations and its broad collateral framework. Other central banks had to
innovate in order to step up their intermediation role by resorting to specific targeted
facilities outside their standard operating environment.
Modalities and parameters of intervention were adapted to local circumstances, such as the
depth and liquidity of financial markets and the degree of intermediation in the financing of
the economy, which differ considerably across major economies. Some would argue that it is
likely that most of the new instruments may not be needed to the same extent once money
market conditions - and more generally the transmission channels of monetary policy -
return to normal. But is it so likely? This immediately brings up the question that the panel is
posing: "Where to exit to?". We may want to ask ourselves which elements of our current
mode of operation have served us well, and not only as a crisis management tool, and may
therefore survive as a more permanent feature of the new steady state.
So, let me share some thoughts on what remains unresolved about the issues that I
mentioned at the start. I see four open questions, and I want to be very honest: I will not give
answers. First question: the size and degree of symmetry of the interest rate corridor.
Second question: the duration and maturity of central bank operations. Third question: the
mode of the liquidity provision to banks. And fourth, the shifts in amplitude and quality of
collateral pools, and the risk management implications associated with these shifts.
Let me start by discussing the interest rate corridor. As I mentioned already, the ECB entered
the crisis with a tradition of conducting policy through a corridor - others would say, a
"channel" - system. The ECB's corridor is determined by the two overnight standing facilities:
the marginal lending facility and the deposit facility. These standing facilities were set
symmetrically around the main policy rate charged on central bank credit at the weekly
refinancing operations. Prior to the crisis, the quantity provision at our weekly operations was
calibrated in such a way that, given banks' liquidity needs, the overnight money market rate
would settle close to the policy rate. So, the corridor was symmetric de jure and de facto:
liquidity volumes were just sufficient to validate the mid-point of the corridor as the price of
liquidity to which market overnight rates would gravitate on average.
At the onset of the crisis, we moved quickly from a system of liquidity provision geared
towards filling the system's liquidity deficit towards a set-up in which banks operate under
aggregate excess liquidity. So, following the shift to a fixed-rate full allotment mode of
liquidity provision in October 2008, overnight money market activity rapidly occupied the
lower half of the corridor, and in fact, with few interruptions, the overnight rate has been close
to the floor of it ever since. For all practical purposes, the relevant portion of the corridor for
daily market activity has shrunk to the space existing between the rate on the main
refinancing operations - on the upside - and the rate on the deposit facility - on the
downside.
Should the corridor be brought back to its standard width - spanning the entire distance
between the marginal lending rate and the deposit facility rate - not only de jure but also de
facto? In other words: should we go back to the standard quantity-based technology of
liquidity provision which was founded on the principle of balanced liquidity conditions? Or
should we maintain excess liquidity and operate the system through parallel adjustments to
the deposit facility rate and the rate on the main refinancing operations?
I am asking this question, because observers - Marvin Goodfriend1, for example - have
been arguing for a system where the monetary authorities adjust a policy floor - the rate paid
on reserves or the deposit facility rate - and the system is saturated with excess liquidity, so
that overnight market rates are kept close to the floor.
Let me expound the merits and drawbacks of the discussed system, again upon the premise
that I do not have a quantitative scale to weigh the ones against the others.
•
First advantage: the volatility of the overnight rate would likely be squeezed to
minuscule numbers. True, our overnight rate has been more - rather than less -
volatile since it moved to the floor of the corridor. But it is also true that excess
liquidity conditions have been unsteady and uncertain in the past. Here, I imagine a
scenario in which the liquidity supply would be kept steady and reasonably
predictable. A more stable overnight rate, it has been argued, could enhance the
transmission of policy shifts - adjustments to the deposit facility rate - throughout
the term structure of money market rates.
•
Second advantage: the central bank would maintain one important acquisition from
the crisis period: that is, its capacity to disentangle interest rate decisions from
decisions concerning the scale of its own liquidity operations in order to remain
resilient to large-scale liquidity shocks. This possibility may come in handy at the
time of exit, in situations when inflation risks would call for a tightening of policy,
while concerns about the fragility of the banking system would suggest prolonging
the horizon for easy access to central bank credit. But even in the steady state -
after the exit - the new system would be marginally more resilient to large liquidity
shocks and acute liquidity stress in the money market. Banks would receive funding
certainty, as their liquidity needs would be met. But there are drawbacks as well.
First, for the ECB at least, this would require banks to be willing to hold reserves in
excess of their needs. In a normal situation, absent any financial stress, this is
difficult to ensure in a system (like ours) in which liquidity injections are the
consequence of counterparties' - not the central bank's - decisions. Second,
importantly, a system of permanent excess liquidity could potentially distort signals
of liquidity and credit risk in the money market, as money market activity could be
compressed - or suppressed altogether. I will come back to this point in a short
while.
Let me turn to the second issue, the duration and maturity of central bank operations. In our
case, before the crisis, the bulk of liquidity was provided through operations with a maturity of
one week. We also provided (pre-set) amounts through longer-term operations, but to a
lesser extent and with a maximum maturity of three months. As an alternative, one may
conceive of frameworks in which the menu of maturities open for bank borrowing would be
much richer. For example, there could be merits in matching the more structural long-term
trends in the autonomous liquidity factors, most notably the growth in currency in circulation,
with corresponding instruments of structural liquidity supply at longer maturities. Expanding
the range of maturities following the exit would probably go hand-in-hand with the decision to
return to competitive auctions. But such a steady state framework would be nevertheless
more robust to renewed bouts of perceived funding risk in the market.
Let me turn to the third - very much related - issue: the most appropriate mode of liquidity
provision and the desirability of market versus central bank intermediation.
Before the crisis, the intermediation role of the ECB was limited to filling the structural
"liquidity deficit" of all the banks vis-à-vis the monetary authority. The pre-crisis weekly
liquidity provision through variable rate competitive auctions was thought to be best suited to
reveal banks' "true" liquidity demand, incentivise interbank transactions, and enhance market
scrutiny of banks' credit standing, beyond the quality of the collateral that they could pledge
in our lending operations.
de facto
But, during the crisis, we have moved to a system in which the central bank is the
"market intermediary" of last - and sometimes - first resort. This has further weakened
banks' incentives to trade liquidity in the market. Do we need them to trade in the very
shortterm market in the first place?
Well, this is a fundamental issue for optimal mechanism design. It is not entirely clear
whether an interbank market is strictly needed from a welfare perspective. The key function
of markets is price discovery. But here the price to be discovered is not only the starting point
of parties' negotiations, but also the end-point of the market tâtonnement: it is the price
preset by the central bank! So, some would argue: why do we need a market if the price is
predetermined? Of course, I am over-simplifying. The welfare function of the secured money
market probably differs and is less important than that of the unsecured money market,
where the market exercises a type of discipline that a central bank backstop would not be
able to provide.
Let's not forget moral hazard considerations. In stressed systemic conditions, banks may
well be deprived of access to interbank credit for reasons that have little to do with their own
merit of credit. These are conditions that require central bank interventions to replace the
market, when this fails. But in normal times, banks which are kept out may be those that
deserve credit restrictions. In this case, a central bank taking away market pressure would
distort the market, not repair a market imperfection.
Also, allowing the price to be determined by competitive forces may have the collateral merit
of revealing market information which is certainly of great value to the central bank.
Maintaining an active market for liquidity may be an important pre-condition for the central
bank to monitor important variables, such as the evolving market standing of single
institutions and the dynamic process by which banks evaluate and price liquidity risk.
Finally, let me briefly address the fourth and last issue: the collateral framework. The crisis
has underscored the importance of the collateral framework for monetary policy
implementation. I believe there is still much to learn in this area. Ideally, any decision on the
collateral framework under a new steady state should be based on a thorough examination
of the impact of collateral valuation and haircuts on the size and composition of banks'
balance sheets, and the ramifications for the stability of the financial sector as a whole. Such
an examination cannot be conducted in isolation from a review of collateral rules followed in
private transactions, which could be affected by the on-going regulatory overhaul, in
particular the migration of over-the-counter derivatives to clearing houses.
Concluding remarks
The ECB's operational framework, conducting monetary policy operations as temporary
refinancing operations in a corridor system, has not only served us well. It has also provided
us with enormous flexibility during the crisis. By adjusting the price, amount, maturity,
allotment procedures and eligible collateral for our operations we have been effective in
containing funding risks of banks and in addressing distress in the money market. In a sense,
the system can well be rolled back to the previous steady state, with the comforting
expectation that this flexibility is a built-in permanent mechanism that restores itself again,
elastically, in case of need. Yet, some of the questions I posed may be worth reflecting upon.
And I am grateful to the organisers of this conference for stimulating discussion of these
issues.
Before turning the floor to the other panellists, let me briefly add some further points on the
interactions between exiting non-conventional monetary policy and financial stability.
Exiting the crisis mode could pose risks to financial stability in the current environment, which
is marked by a prolonged period of low yields and reduced volatility, making it challenging for
the financial sector to properly accommodate interest rate risk. The exit could be associated
with a steepening of the yield curve as expectations of low short-term rates are reversed and
central banks reduce their holdings of long-term securities. Uncertainty on the path of exit
from unconventional policies may trigger a rise in volatility at the long end of the yield curve,
exposing banks and investors to substantial losses. These effects would be more
pronounced if the speed of interest rate adjustment were to exceed market expectations.
At the same time, delaying the exit from "crisis" monetary policies beyond what central
banks' reaction function would warrant could also entail risks to financial stability, by inducing
a further build-up of the very same exposures that render exit more challenging in the current
environment. In particular, a protracted period of low interest rates and ample liquidity could
compromise the market mechanisms in efficiently allocating resources, hence encouraging
the roll-over of loans to non-profitable businesses and weakening incentives for balance
sheet repair. Prolonging low interest rates for a long time might raise the possibility of sudden
shifts in market expectations and significant re-pricing of risks once indications of monetary
policy tightening materialise.
Of course, these risks should also not be overrated at a time when financial risks are
currently highly correlated with overall macroeconomic risks. Exit is very likely to take place
in an environment where credit has recovered and risks have receded in the economy,
making the financial sector more robust to interest rate shocks. The current situation of
subdued bank lending and outlook for growth in the euro area is a case in point.
Yet, monetary policy-makers have to be aware of these challenges and need to guard
against the risk of financial dominance by keeping a clear focus on their respective mandate.
For the ECB, our "hardwired" focus on price stability provides a clear guidepost that has
proved effective in anchoring inflation expectations over time. And the prominent role given
to money and credit developments in our strategy ensures a more symmetric reaction to
financial forces over the cycle.
At the same time, it is important that central banks continue to place particular emphasis on
managing expectations. The ECB has all the instruments at hand to ensure a smooth exit if
risks to medium term price stability should materialise. Our credit operations are temporary
and the market has all the information to date to anticipate their unwinding and make
adequate adjustments to prepare. If liquidity conditions should prove too lax while central
bank credit is still abundant, we have available instruments of liquidity re-absorption to
tighten money market. Some of these instruments have been tested successfully in the
course of the crisis.
Finally, let me stress that a sound financial system is a necessary condition for an orderly
exit, hence the importance of a swift implementation of the banking union in the euro area.
This should include not only the Single Supervisory Mechanism but also a Single Resolution
Mechanism, with a single resolution fund based on contributions by the industry and a
common, last-resort fiscal backstop. This also includes the assessment of banks' balance
sheets that will be undertaken in the transition to the Single Supervisory Mechanism.
I thank you for your attention.