Benoît Coeuré: The European Central Bank's operational framework in
post-crisis times
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the Federal Reserve Bank of Kansas City Economic Symposium "Designing resilient
monetary policy frameworks for the future", Jackson Hole, Wyoming, 27 August 2016.
* * *
I would like to make some comments this morning on the challenges that lie ahead for
central banks and how our monetary policy frameworks should adapt to them. I will
admittedly be asking more questions than giving answers. I won't be giving any definitive
guide to the future shape of the ECB's monetary policy framework. What I will offer is my
view on some of the key issues on this topic and pose some questions of relevance to
policymakers.
Monetary policy operational frameworks concern the intermediate targets of central banks
and how they meet them. This is distinct from monetary policy strategies, which concern the
quantitative definition of policy objectives, the horizon over which they should be delivered as
well as the organisation and weighting of incoming information.
Operational frameworks can be designed along two main dimensions: (i) the operational
target for monetary policy; and (ii) the measures used for implementing that target, which
include the mode of liquidity provision or absorption, the counterparties that are eligible to
take part in those operations and facilities, and the choice of collateral which is accepted in
reverse repo operations. Where central banks position themselves along these dimensions is
clearly path-dependent but it depends, among other things, on institutions and financial
structures. A comparison between the pre-crisis frameworks of the Federal Reserve and the
ECB illustrates the different possible constellations.
While both central banks had similar operational targets - de facto one or more very
shortterm interest rates - the asset side of the Fed's balance sheet consisted mainly of outright
holdings of US government bonds, considered as a safe asset. The Fed also steered liquidity
conditions, at the margin, via repos, whereby the collateral set was narrow and again
dominated by that safe asset. By contrast, the ECB, lacking a single fiscal counterpart and
operating across multiple jurisdictions, injected liquidity mainly through repos with banks and
deployed a wider collateral and counterparty framework (albeit with appropriate credit
safeguards). Credit was provided to around 1,800 counterparties, against a set of collateral
that comprised many different asset classes.
The ECB's operational framework proved flexible when the crisis hit, helping cushion the
initial financial turbulence. And as the crisis unfolded in successive "waves" and materially
altered our market environment, we adopted further measures to meet the new challenges
we faced. We are thus now presented with an important question- should we treat these
changes as temporary imperatives that should be withdrawn as soon as conditions permit, or
should they form a permanent part of our operational framework?
To answer this, we need to ask: of all the challenges we have faced during the crisis, which
ones are likely to persist? And which measures should we retain to deal with them? In my
view, there are two challenges that stand out. The first is how monetary policy should adapt
to structural shifts in financial intermediation. The second is how to cope with the constraints
imposed on central banks by the effective lower bound of interest rates.
Shifts in financial intermediation
Financial intermediation in recent years has been characterised by two structural shifts, one
of which was specific to the euro area and one of which is global.
In the euro area, financial markets underwent severe spatial fragmentation in the early phase
of the crisis, with intermediation retreating behind national borders and impairing the bank
lending channel of monetary policy. Many of the changes to our operational framework
during the crisis were a reaction to this. For example, the move towards fixed-rate full
allotment liquidity provision, the widening of our collateral framework and the extension of the
maturity of our lending operations acted as crucial stabilisers and averted sudden stops in
market funding for national banking systems.
While this problem has now largely disappeared, it would be complacent to see it as
completely resolved. Some key components of our banking union (such as the build-up of
the Single Resolution Fund and the removal of national options and discretions in bank
supervision) are still being phased in, and some key drivers of fragmentation, such as the
bank-sovereign nexus, remain unsolved - not to mention a lingering risk of political
fragmentation.
The second structural shift in patterns of intermediation, a global one, is linked to financial
regulation. Tighter financial regulation is both increasingly affecting the behaviour of
supervised entities, and encouraging a parallel shift towards unregulated forms of finance.
This dual process has repercussions for monetary policy implementation. It increases
demand for safe short-term instruments to meet new regulatory requirements, such as the
liquidity coverage ratio and margin requirements for derivatives. And it fosters the use of
prime collateral for lenders in unregulated forms of finance as a form of self-protection. This
is not necessarily undesirable: a higher share of non-bank financing is intended in the EU as
part of the capital markets union project and will make our financial system more resilient to
shocks originating in the banking system.
But these shifts raise important questions for central banks' operational frameworks. In my
view the tail risk of spatial fragmentation is an argument for retaining certain elements of our
crisis framework, in particular our "wider" collateral policy.
The same could be said for the fixed-rate full allotment mode of liquidity provision. In the new
regulatory environment there may be a need to accommodate a structural excess demand
for liquid and safe financial claims. This may call for a framework where the central bank can
separate the level of reserves from the level of policy rates on a permanent basis. Fixed-rate
full allotment would support such a disentangling of interest rates from liquidity conditions.
Another question is how to adjust our framework in response to the growth of non-bank
finance in Europe. A more market-based financial structure may make it easier for us to
provide liquidity via outright purchases, which may in turn become more important as a
regular instrument of policy if we operate in a framework of excess reserves. In that
environment, the quantity of liquidity to be supplied could become a quasi-intermediate target
almost on a par with the level of the policy rate. But then we could not rely solely on "passive"
lending operations to deliver the right stance of policy: we would need a more active
instrument to inject the "right" quantity of reserves.
But all this could have drawbacks as well. First, the monitoring costs and complexity of a
wide-collateral and counterparty framework are higher. Second, a framework based on
fixedrate full allotment would to some extent weaken signals of liquidity and credit risk in the
money market. Third, and most importantly, the responsibility for generating safe assets
should not only fall on central banks, but on fiscal issuers - not necessarily by issuing more
bonds, which may make them less safe, but by improving the credibility of their fiscal
frameworks. In the euro area, common debt issuance could one day support this objective, if
done in a way which does not undermine incentives for sound fiscal management.
The effective lower bound on interest rates
Moving to the second challenge - the effective lower bound - recent evidence suggests that
real neutral rates have fallen to very low levels, driven by both cyclical and structural forces.1
This challenge is common to advanced economies but it is more pronounced in the euro
area than in the US, given its markedly lower rate of potential output growth. In this context,
all major central banks reduced interest rates to very low levels, thereby approaching the
effective lower bound on interest rates. They responded to this via different measures:
providing forward guidance, launching large-scale purchases of public and private sector
assets, and - in our case - by implementing a negative interest rate policy, which has in fact
uncovered that the effective lower bound is lower than was previously thought.
These measures have been very effective in supporting output and inflation and anchoring
medium-term price stability. However, they were taken on the implicit assumption that they
would be transient, both because monetary stimulus would help counter the cyclical forces
depressing the real equilibrium rate and because other economic policies would provide
cyclical support and tackle the more structural drivers of low real rates. But if other economic
policies do not in fact play this role, then we cannot exclude that the real equilibrium rate
remains low. As such, we may see short-term rates being pushed to the effective lower
bound more frequently in the event of macroeconomic shocks; and the stimulus provided by
lowering interest rates to that level would be of course be much weaker.
For central banks to retain a handle on output and inflation, then, unconventional policies
may have to be deployed more frequently. But this would come with at least three
complications.
First is the question of the operational target. A target focused on short-term interest rates
makes sense when this is the main policy variable, but if short-term rates are persistently
pushed towards the lower bound, monetary policy has to focus on a wider constellation of
rates across different maturities and asset classes. What then is its target? Central bankers
currently offer quantity targets in these cases - a volume of assets to be bought per month -
but price targets are only given in general terms, for instance "flattening the yield curve". This
is appropriate so long as balance sheet policies are temporary. It may not be in the long
term, but moving to price targets may come at the expense of price discovery.
This links to the second complication: balance sheet policies can mitigate certain facets of
the safe asset shortage, but they might exacerbate others. In particular, balance sheet
policies have been stimulative by swapping central bank money for assets with duration and
credit risk. But over time, if monetary policy continues to withdraw long-dated safe collateral
from the market, there is a risk that it has a countervailing effect - i.e. that it exacerbates safe
asset hoarding at the long end of the yield curve. As various academics have documented2,
this could eventually put further downward pressure on real equilibrium rates.
Central banks have responded to this by re-lending their portfolios of securities. But this is
only a temporary fix. The first best solution would clearly be for fiscal issuers to generate
more safe assets under the conditions outlined above. If this does not happen, central banks
may have to use their own balance sheets to satisfy safe asset demand, also at longer
maturities.
A third complication is that extended use of unconventional measures could come with rising
side effects, for instance on financial stability, financial intermediation and international
spillovers. Thus far, the benefits of such measures have clearly outweighed their costs, but
we cannot rule out a situation where the side effects are such that the negative
consequences prevail. When discussing negative interest rates, I have called that tipping
point the "economic" lower bound, in contrast to the "physical" lower bound, where
largescale substitution with cash materialises, a point which has clearly not been reached.3
This could mean a more frequent use of micro- and macroprudential measures to oppose the
adverse financial stability effects of very low rates, also in countries affected by international
spillovers. It could further accelerate shifts towards non-bank forms of intermediation with the
consequences I described above. And it may mean moving towards a regime of greater
international cooperation and policy alignment to avoid a situation where the effective lower
bound leads to competitive devaluations.
Conclusion
Let me conclude.
Today, we face an exceptional situation where the real equilibrium rate is very low. All the
monetary policy measures we have taken were a necessary response to this. They stabilised
the euro area economy and anchored medium-term price stability. But they were done on the
assumption that low real rates would be temporary, because other policies would act in their
fields of responsibility.
The ECB's operational framework and its monetary policy strategy are robust and sufficiently
flexible to deal with the current challenges. We will fulfil the price stability mandate given to
us by the Treaty. But if other actors do not take the necessary measures in their policy
domains, we may need to dive deeper into our operational framework and strategy to do so.