Conference of the Chair BdF/PSE, Paris School of Economics
Current Challenges of Monetary Policy
September 24, 2019
Speechi by François Villeroy de Galhau,
Governor of the Banque de France
Press contact: Mark Deen (mark.deen@banque-france.fr).
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Ladies and Gentlemen,
It is a particular pleasure to welcome you on the occasion of the 10th
anniversary of the Chair Banque de France/PSE. All anniversaries are worthy
of celebration, but the continued partnership of Banque de France with the
Paris School of Economics is a particular reason for cheer. Over the past ten
years, it has been a testimony of how academic research and economic policy
making can reinforce each other.
In the past ten years, thanks to their interaction, much has been done to make
our financial environment more capable of reining in financial excesses.
Thanks to both, we have introduced many new unconventional tools to
implement monetary policy. But these changes have also brought new
questions and new uncertainties, on which more academic research is
needed. Hence, I would like to elaborate on two present challenges: the
conduct of monetary policy in our current economic environment, and the
interaction between monetary policy and financial stability.
**
1. Monetary Policy in the Face of New Challenges
1.1. A New Environment Calling for New Responses
These new uncertainties arise at a time when the global economic
environment has itself become increasingly uncertain. In the short term, many
of the uncertainties obstructing the economic outlook - and especially the
manufacturing sector - are man-made - and even one-man made.
Contingencies that not so long ago appeared as tail risks, such as the
possibility of an escalation of trade tensions or a disorderly Brexit, have
become looming threats.
But uncertainty also pertains to long-term structural trends. Over the past
decade, the world economy has steadily recovered from the global financial
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crisis. But it has not returned to its pre-crisis normal. Interest rates remain at
historical lows, due to a historically low level of the natural rate of interest R*ii.
In the short run, this analysis - uncertainty as the first trigger of the present
slowdown - should guide our ranking of policy answers. Monetary policy plays
its role, but it should not - less than ever - be the only game in town. It should
not even be the first game in town. The first response would be for
government-driven uncertainties to be addressed directly by governments, by
removing the self-induced threats to world growth.
Failing that, a second answer is for fiscal policy to step in. Fiscal stimulus from
countries with fiscal space would both stimulate aggregate demand, and, with
targeted, quality investment, increase long-term growth.iii Wage increases in
countries that have long relied on wage moderation could also help in
bolstering aggregate demand and inflation. And pro-growth reforms would
raise R*.
Monetary policy provides a third response. For the past ten years, there is little
doubt that ECB monetary policy under Mario Draghi's Presidency has made a
decisive contribution not only to safeguarding the euro in 2012, but also to the
significant recovery of the euro area since 2013. Over this period, more than
10 million jobs have been created. Our unconventional measures are
estimated to add almost 2 percentage points of growth and of inflation
between 2016 and 2020. Since I am talking to an audience of researchers I
should of course emphasise that such numbers are subject to uncertainty.
However, the most recent monetary policy decisions of the Governing Council
have given rise to many comments. My rule of conduct has been to not add
mine in the heat of the moment. Two weeks later, let me only say that I
supported many elements of the package, including the strengthening of the
state-dependent forward guidance and the welcome introduction of a tiering
system, similar to those in all other jurisdictions with negative interest rates.
But I was not in favour of the resumption of net asset purchases at this time,
because I thought that further purchases are unnecessary right now, given
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the very low levels of both long-term interest rates and term premia, which
have continued to decrease significantly since we stopped net purchases last
December. The main purpose of QE is to extract more duration risk from the
bond market; indeed, term premia have already been successfully
compressed - the term premium on a 10-year OIS is estimated to be
significantly negative at around -60 to -100 bp. I also think that the significant
strengthening of our forward guidance, the consequent prolongation of the
reinvestment period for the very important stock of QE assets - 2600 billion
euros -, and the DFR cut, were already a powerful and consistent
combination. The forward guidance now states that we expect rates to remain
at their present levels, or lower, until the inflation outlook robustly converges to
a level sufficiently close to, but below, 2%, and this convergence has been
consistently reflected in underlying inflation dynamics: our forward guidance is
now strongly "state based", reflecting our enhanced commitment to reach our
objective. This is significant progress that has been overshadowed by the
arguments over QE.
For me, it is not a question of a shifting balance between hawks and doves - I
have never found ornithological categorisation to be of much help in designing
monetary policy. It is a question of pragmatic and objective economic analysis,
which takes market expectations as useful indicators but is not dependent on
them.
But whatever the debate in the Governing Council has been, let us now look
forward and stress one simple message that has unanimous agreement:
monetary policy has, once more, done its duty. It is now up to other policy
makers to do theirs, starting with the fiscal authorities. As Mario Draghi pointed
out yesterday in front of the European parliament, "We need a coherent
economic strategy in the euro area that complements and enhances the
effectiveness of monetary policy".
1.2 Specific Challenges for Monetary Policy
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This is not however a call for self-congratulation: we have to do our homework
on some renewed research questions, where we cannot live with our old
metrics and our present lack of knowledge. For that, we need more than ever
your research and our dialogue.
First, the measurement of key structural determinants remains surrounded
with uncertainty. I mentioned the uncertainty surrounding the trend in R*. But
similar uncertainty pertains to the measurement of potential output and the
natural level of unemployment U*iv. We should also intensively work on the
economic effects of climate change as a long-term but significant shock, and
its interaction with monetary policy.
How to best measure inflation expectations is a second key issue. We know
that expectations are key determinants of inflation, but it remains unclear what
the most relevant measures of inflation expectations are. Expectations of
professional forecasters (at 1,7 %) and market-based measures (at 1,3 %)
have received most of the attention until now, but the expectations of firms as
well as households - which can be significantly higher - matter at least as
much for aggregate demand and price-setting. As Benoît Coeuré rightly
stressed last July, more research is needed on what their expectations are,
and how they form them.v
Third, there is still much we do not know about how firms and households form
expectations on future interest rates, and on how these expectations affect
their spending decisions. We know that standard DSGE models tend to
assume too much foresight from private agents. How to incorporate more
realistic behavior is a central issue, especially when forecasting the effects of
our new instruments such as forward guidancevi. To be sure, some uncertainty
over the response of the economy to our policies will always remain, especially
when firms and households are themselves still learning how our new
measures affect the economy, and how to live with very low or negative
interest rates.vii
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A last topic deserves, I believe, particular attention: the possible side-effects of
our monetary tools on financial stability, especially the effects of
unconventional monetary policies.
2. Monetary Policy and Financial Stability
2.1 Prudential Policies and Monetary Policy are Complements not
Substitutes
To address concerns over financial stability, regulation and supervision, both
microprudential and macroprudential, are of course available and essential.
On financial regulation, ten years after the financial crisis, we must resist the
temptation to unpick what has been done, and the complacency to believe that
"this time is different".
Macroprudential policy is essential to foster financial stability. However,
macroprudential policies have their limits. To start with, as of today, our toolkit
is very much bank-centric. We are making some progress to extend
macroprudential policy beyond the banking sector. But we should
acknowledge that we are not there yet and that this is becoming a pressing
issue as the non-banking sector is developing in reaction to the macrofinancial
environment and changes in the regulation framework.
In addition, as our macroprudential arsenal is still rather new and untested,
uncertainty remains on the quantitative magnitude of the effects of our
interventionsviii. Experience will teach us how to adapt and adjust our policies
over time, but uncertainty will remain a feature of real-world policy-making.
Finally, we should refrain from hubris: over time, we will design a more
comprehensive macroprudential toolkit and learn to make the best use of it.
But while macroprudential policies can certainly contribute a lot, some root
causes of financial crises will remain out of their reach and macroprudential
policies alone would fall short of achieving financial stability.
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If prudential policies have limitations, it is legitimate to ask whether monetary
policy should take into account financial stability concerns or even assist
prudential policies. To be sure, monetary policy has drawbacks as an
instrument to foster financial stability. In particular, it cannot target specific
risks. But as Jeremy Stein noted, the bluntness of the tool is also its strength: it
affects all financial players.ix
Let me take a step back. Central banks have an operational independence but
they do not decide their own mandate. The mandate given to the Eurosystem
is clear: our primary objective is price stability. However, our mandate states
that we "shall contribute to the smooth conduct of policies pursued by the
competent authorities relating to the prudential supervision of credit institutions
and the stability of the financial system"x.
Careful attention to the dynamics of the indebtedness of households, firms,
and financial intermediaries would also be in line with the intellectual tradition
of the Eurosystem. Since its inception, the ECB has always given special
attention to broad financial aggregates in setting the course of monetary
policy. It was emphasised by its monetary pillar and is now emphasised by its
monetary analysis. Restricting attention to measures of liquid liabilities such as
M3 has probably little justification today in view of the little direct relevance of
monetary aggregates for price developments. But the relevance of broader
and more varied credit aggregates is beyond question for both price and
financial stability concerns. Together with asset prices, they could constitute
the base of a revised credit and financial pillar.xi
2.2 The Separation Principle becomes less relevant with a multifaceted
monetary policy
The link between monetary policy and financial stability raises two questions.
First, what are the quantitative effects of monetary policy instruments on
financial stability? We have enough evidence by now that interest rate policies
can have effects on indebtedness, risk-taking (through maturity transformation,
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search for yield, or other channels) and the profitability of financial actors. It
would therefore be short-sighted to ignore the side effects of monetary policy
on financial stability. Second, are these effects large enough to make it
possible to preserve financial stability without compromising price stability? At
this point, the precise terms of a possible trade-off are still being debated.xii
The issues are complex: as Nuno Coimbra here at PSE emphasises in a
paper with Hélène Rey, a decrease in interest rates can encourage risk-taking
when interest rates are low, but discourage it when interest rates are high.xiii
We need more work on this important issue.
Let me just suggest two thoughts on this open issue.
a/ Incorporating Financial Stability Concerns with an Extended Monetary
Toolkit
First, the binary opposition between the traditional separation principle and
"leaning against the wind'' makes less sense when monetary policy has itself
several instruments at its disposal. A median way, which we could call
"coordinated" or "integrated" is possible. Indeed, that several instruments can
allow to pursue several objectives is just what the old Tinbergen rule asserts.
This is particularly relevant within monetary policy in our current context. Over
the past years we have brought innovations to our operational framework, and
we have considerably extended our toolkit with balance-sheet policies such as
quantitative easing and (T)LTROs. Like our time-honed interest-rate policy,
these balance-sheet policies were introduced with price-stability objectives in
mind. But now that our extended toolkit has brought us new degrees of
freedom, it is valuable to think of how this new flexibility could be used in the
long-run to minimise financial stability risks without compromise to price
stability.
Let me illustrate it with the example of tiering. The tiering system we have
decided upon will allow our interest rate policy to deliver price stability without
trading it off against financial stability. Far from entering into conflict with price
stability, tiering will actually also ensure that our policies have their intended
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effect on price stability, by alleviating the risk of a reduced pass-through of our
policies to the financing cost of the private sector. And it may enhance the
monetary policy stance by mitigating the side effects of keeping rates lower for
longer.
There is no reason to commit one particular monetary instrument to the
financial stability objective. Instead, a parallel with public finance can prove
useful. It is customary in public finance to see the problem of choosing tax
rates as one of minimising the distortions created by various tax instruments,
in order to raise a given amount of revenues. Similarly, it is possible to
approach our monetary policy decisions as one of choosing the combination of
instruments that minimise risks to financial stability, in order to deliver the
policy stance called for by our price-stability mandate.
Likewise, some of our new instruments could be more efficient to address
financial stability concerns. For instance, under some dimensions, balance-
sheet policies differ markedly from interest-rate policies. By providing valuable
safe assets to banks - central bank reserves - a high level of central bank
reserves can support their smooth functioning. Even more importantly, it can
mitigate the risk that banks will try to supply the demand for safe assets by
engineering them themselves. Privately issued safe assets are poor
substitutes for public safe assets.xiv
b/ Keeping the purchase of private assets to a minimum
In any case - and this is my second remark - the purchase of private assets
by the central bank should be kept to a minimum. Indeed, the asset-side of the
balance-sheet - what assets the central bank buys with the reserves it issues
- matters a lot. Buying an excessive amount of private assets such as
corporate bonds could run the risk of distorting the signal that asset prices
convey on the assets' riskiness. The present compression of risk premia and
credit spreads might already increase risks to financial stability.
**
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Conclusion
I have restricted my remarks on financial stability to the policies that fall, at
least in part, within the realm of a central bank. However, as I have
emphasized earlier, monetary and prudential policies are not the only policies
available. Due to the present economic environment, fiscal policies and
structural reforms can and should be more and more part of the policy mix. But
it also follows from the guiding principle that I have highlighted today: the more
tools available, the easier it is to combine them to minimise the trade-offs
between price and financial stabilities.
Fiscal policy can help monetary policy in fostering financial stability in several
ways. First, it can of course help by taking away some of the burden of policy
accommodation. But fiscal policy can also directly assist monetary policy in
fostering financial stability. It can help monetary policy to provide the safe
assets necessary to a resilient financial system, if possible including in the
form of a euro area-wide safe asset. On the tax side, it should reduce all
excessive incentives towards real-estate investment, and foster a more neutral
allocation of savings according to a sound reward of risk. Let me end with one
question: what will monetary policy be like in ten years? We clearly can't be
certain of anything, but we can at least share a conviction: the more progress
we have made together on these issues I mentioned, the better our monetary
policy will be. Thank you for your attention and your cooperation.
References:
-Adrian Liang (2018), Monetary Policy, Financial Conditions, and Financial Stability,
International Journal of Central Banking
-Aiyar Voigts (2019), The Negative Mean Output Gap, IMF Working Paper 19/183
-Ajello Laubach Lopez-Salido Nakata (2019), Financial Stability and Optimal Interest Rate
Policy, International Journal of Central Banking
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-Bernanke Kiley Roberts (2019), Monetary Policy Strategies for a Low-Rate Environment,
Finance and Economics Discussion Series 2019-009
-Blanchard (2019), Public Debt and Low Interest Rates, American Economic Association
Presidential Lecture
-Brand, Bielecki, Penalver (2018), The natural rate of interest: estimates, drivers, and
challenges to monetary policy, ECB Occasional Paper Series n°217
-Cerra Saxena (2008), Growth Dynamics: The Myth of Economic Recovery, American
Economic Review, Vol. 98 No. 1
-Coibion, Gorodnichenko, Kumar (2018), How Do Firms Form Their Expectations? New
Survey Evidence, American Economic Review 108, p. 2671-2713
-Coibion, Gorodnichenko, Ropele (2018), Inflation Expectations and Firm Decisions: New
Causal Evidence, NBER Working Paper No. 25412
-Coibion Gorodnichenko Ulate (2019), The Cyclical Sensitivity in Estimates of Potential
Output, NBER Working Paper No. 23580
-Coimbra and Rey (2019), Financial Cycles with Heterogeneous Intermediaries, NBER
Working Paper No. 23245
-Del Negro Giannoni Patterson (2012), The forward guidance puzzle, Federal Reserve Bank of
New York Staff Report No. 574
-Gabaix (2019), A Behavioral New Keynesian Model, NBER Working Paper No. 22954
-Gourio Kashyap Sim (2018), The Trade offs in Leaning Against the Wind, IMF Economic
Review, 66:70-115
-Greenwood Hanson Stein (2015), A Comparative-Advantage Approach to Government Debt
Maturity, The Journal of Finance, VOL. LXX, NO. 4
-Greenwood Hanson Stein (2016), The Federal Reserve's Balance Sheet as a
FinancialStability Tool, Jackson Hole Symposium
-Hamilton Harris Hatzius West (2019), The Equilibrium Real Funds Rate: Past, Present, and
Future, IMF Economic Review Vol. 64, No. 4
-Hartmann Smets (2018), The first twenty years of the European Central Bank: monetary
policy, ECB Working Paper Series
-Holsten Laubach Williams (2017), Measuring the natural rate of interest: International
trends and determinants, Journal of International Economics 108, S59-S75
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-Monnet (2014), Monetary Policy without Interest Rates: Evidence from France's Golden Age
(1948 to 1973) Using a Narrative Approach, American Economic Journal: Macroeconomics,
Vol. 6, No. 4 (October 2014), pp. 137-169
-Monnet and Vari (2019), Liquidity Ratios as Monetary Policy Tools: Some Historical Lessons
for Macroprudential Policy, IMF Working Paper 19/175
-Nakamura Steinsson McKay (2016), The Power of Forward Guidance Revisited, American
Economic Review, Vol. 106, No. 10
-Orphanides van Norden (2002), The Unreliability of Output-Gap Estimates in Real Time,
Review of Economics and Statistics 84(4), p. 569-583
-Rostagno et al. (2019), A Tale of Two Decades: the ECB's Monetary Policy at 20, forthcoming
-Stein (2012), Monetary Policy as Financial-Stability Regulation," Quarterly Journal of
Economics, 127, pp. 57-95.
-Stein (2013), Overheating in Credit Markets: Origins, Measurement, and Policy Responses,
Speech
-Svensson (2017), Cost-benefit analysis of leaning against the wind," Journal of Monetary
Economics, vol. 90(C), pages 193-213.
-Woodford (2016), Quantitative easing and financial stability, Journal Economía Chilena (The
Chilean Economy), Central Bank of Chile, vol. 19(2), pages 04-77
-Woodford (2018), Monetary Policy Analysis when Planning Horizons are Finite, NBER
Working Paper No. 24692
i
I would particularly like to thank Matthieu Bussière, Stéphane Dupraz, Mark Deen, and Olivier Garnier for their
help in preparing this speech.
ii
On the measurement of the natural rate of interest and the uncertainty surrounding its long-term component,
see e.g. Holsten, Laubach and Williams (2017), Hamilton et al. (2019), and Brand, Bielecki and Penalver (2018).
iii
On the opportunity of relying on fiscal policy in a low-rate environment, see e.g. Blanchard (2019).
iv
On the issues surrounding the measurement of potential output and natural unemployment, see e.g.
Orphanides and van Norden (2002), Coibion, Gorodnichenko and Ulate (2019) and Aiyar and Voigts (2019).
v
For early research on firms' expectations, see e.g. Coibion, Gorodnichenko and Kumar (2018) and Coibion,
Gorodnichenko and Ropele (2018).
vi
On the forward-guidance puzzle and possible solutions to it, see e.g. Del Negro, Giannoni and Patterson
(2012), Nakamura, Steinsson and McKay (2016), Gabaix (2019), and Woodford (2018).
vii
See e.g. Bernanke, Kiley and Roberts (2019).
viii
Monnet (2014) and Monnet and Vari (2019), among others of his work.
ix
Stein (2013).
x
Protocol on the Statute of the Eurosystem and the ECB, Article 3.3.
xi
For recent historical accounts of the ECB's monetary policy in general, and monetary pillar in particular, see
Hartmann and Smets (2018) and Rostagno et al. (2019).
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xii
See Svensson (2017) and Ajello et al. (2019) for studies that find that the impact of monetary policy on
financial stability is too small to make it worth the cost on price stability. See Adrian and Liang (2018) and
Gourio et al. (2018) for more nuanced discussions of the key assumptions that matter to the desirability of
leaning against the wind.
xiii
Coimbra and Rey (2019).
xiv
See e.g. Greenwood, Hanson and Stein (2015, 2016) for the role of publicly issued safe assets in preventing
the creation of privately issued safe assets, and Stein (2012) for a formal model of the impact of safe assets on
the severity of fire sales. See Woodford (2016) for a comparison of the fire-sales risks of balance-sheet policies
and interest-rate policies.