Jean-Claude Trichet: Credible alertness revisited
Intervention by Mr Jean-Claude Trichet, President of the European Central Bank, at the
symposium on "Financial stability and macroeconomic policy", sponsored by the Federal
Reserve Bank of Kansas City, Jackson Hole, Wyoming, 22 August 2009.
* * *
It is a pleasure to be part of such a distinguished panel.
In my remarks today, I will discuss three topical issues facing central banks, in particular in
the light of recent events: the relationship between asset prices and monetary policy; the
effectiveness of our standard interest rate instrument; and the design of non-standard
monetary policy measures such as the ECB's enhanced credit support. The ongoing financial
crisis has highlighted the importance of old issues and raised some new questions, for which
I will try to offer an ECB perspective. Exactly four years ago, here in Jackson Hole, I spoke
about "credible alertness" in monetary policy.1 Today it seems opportune to revisit this
concept in light of recent events.
"Leaning against the wind" and monetary analysis
The best way to manage a crisis is to avoid it. Given the important role played by asset
markets in recent macroeconomic dynamics, the experience of the past few years has given
renewed impetus to the debate on asset prices and monetary policy. Would making
monetary policy more responsive to asset market developments have avoided the financial
crisis? More generally, should monetary policy "lean against the wind" of surging asset
prices?
The academic debate on this issue is ongoing. For instance, there is currently disagreement
regarding the appropriate models and simulations to use when weighing up the pros and
cons of such an approach.2 Within policy-oriented discussions, there has been scepticism
about leaning against the wind for three reasons.3 First, there have been reservations about
the possibility of identifying asset price misalignments or "bubbles" in real time. Second,
doubts have been expressed regarding the ability of interest rate increases of a plausible
magnitude to contain surging asset prices once these have achieved a momentum of their
own. Third, it has been argued that any damage to the economy stemming from an asset
price correction can be contained by prompt and aggressive easing of monetary policy.
What have recent events taught us about leaning against the wind? Allow me to address
each of these three reservations in turn, beginning with the identification of asset price
misalignments in real time.
A number of central bankers were pointing to the underpricing of risk and the excessive pace
of credit expansion in 2006 and 2007.4 While remaining prudent as regards our qualification
of the situation, many of us felt uneasy about the growing financial imbalances emerging in
that period. The increasing risks identified by the ECB's monetary analysis from 2005
onwards, with money and credit growth accelerating to double-digit levels, are well
documented.5 All of this suggests that it was clearly not impossible to identify (albeit not with
precision) the emergence of financial imbalances and misalignments in the pricing of risks -
and therefore also in the pricing of assets - in the years preceding the crisis.
Research findings increasingly support this view. Work at the BIS and the ECB shows that
monetary and credit indicators can provide an early warning where asset price developments
are unsustainable.6 Of course, such indicators are not perfect. There is undoubtedly a risk of
mistakenly leaning against asset price developments that are justified on fundamental
grounds. But policy-makers continually confront such informational problems. Many
indicators used prominently in the formulation of policy decisions are subject to revision and
difficult to measure in real time. Indicators of asset price misalignments are no different. But I
do not believe that such difficulties should be seen as a fundamental obstacle to making an
assessment of the risks posed by excessive asset price developments on the basis of the
information available to us.
Turning to the second reservation expressed in the literature: what of the assertion that
interest rate increases will be unable to halt an asset price surge? Prima facie, to the extent
that an asset price bubble promises to deliver large capital gains, a small change in policy
interest rates is unlikely to alter the balance between the costs of financing the bubble and
the expected profits from investing in it. From this perspective, a policy of leaning against the
wind would appear to have limited value.
It is interesting to see, however, that recent research identifies channels through which even
a small change in policy rates can have important implications. For example, the profitability
of financial institutions that systematically borrow short and lend long can be significantly
affected by even a small change in policy interest rates, triggering the closing-out of
leveraged positions and the moderation of asset price growth.7 To the extent that policy rate
changes break private sector herding behaviour or reveal central bank intentions and private
information, even a small change in policy rates can have a significant impact on asset price
developments.8 Such research suggests that a policy of leaning against the wind may have
greater impact than previously thought.
Turning to the third reservation: what of the alternative approach - i.e. waiting until an asset
bubble bursts and then easing policy aggressively so as to contain the adverse effects on
real activity and inflation? Recent experience has clearly demonstrated the limitations of such
a strategy. Unprecedented policy action has failed to prevent a sharp fall in economic activity
in the context of the financial crisis.9 Moreover, an ex ante approach of this kind risks
creating moral hazard on a large scale, thereby helping to place the system in a metastable
situation, i.e. a state of potential unstability. By contrast, a strategy of leaning against the
wind could reduce moral hazard: by behaving more symmetrically, a central bank can
encourage more responsible behaviour on the part of investors and make a crisis less likely.
Over the past few years, both experience and developments in the literature appear to
support a shift in favour of the adoption of some form of leaning against the wind. However,
having spent 16 years facing the successive challenges of operational central banking, I am
doubtful that such a strategy can be implemented in a mechanical way. The uncertainties
remain too great, and perhaps always will. What is required is a significant degree of
judgement, embedded in a rule-based framework for policy making, which encapsulates the
essence of leaning against the wind without suggesting that central banks are in a position to
manage closely - much less target - developments in asset prices.
In the case of the ECB, the medium-term orientation of our two-pillar monetary policy
strategy calls on us to consider the implications that financial imbalances and asset price
misalignments and their unwinding have as regards the outlook for price developments at
longer horizons. Given that our mandate requires the maintenance of price stability on an
ongoing and continuous basis, rather than at any specific arbitrary horizon, we consider it
important to monitor the slow accumulation of unsustainable financial imbalances which pose
a threat to macroeconomic and price stability over the longer term. Maintaining a
mediumterm orientation, keeping a close eye on monetary and credit dynamics, and adopting a
broader, stability-oriented view of policy making - which are key elements of the ECB's
monetary policy strategy - supports this approach.
Our monetary analysis provides us with a framework within which to assess the dynamics of
asset prices, money and credit from a medium-term perspective. For example, monetary
analysis was decisive in our decision to keep the ECB policy rate at 2%, instead of reducing
it further, in the summer of 2004 and to start raising it in late 2005. On both occasions, the
strength of money and credit growth in the euro area, with liquidity already ample, pointed to
risks to price and macroeconomic stability over the medium term that went beyond those
identified by standard forms of economic analysis. One of these risks was the sustainability
of asset price developments.10 These policy decisions were taken in the face of some
criticism from those who regarded monetary indicators as old-fashioned, including parts of
academia. However, with the (admittedly considerable) benefit of hindsight, most observers
now take the view that such decisions were correctly timed and appropriately judged.
More generally, it was always foreseen that the close monitoring of monetary developments
would provide a framework for addressing asset price misalignments.11 However, viewing
asset price dynamics through the lens of monetary developments integrates them into an
overall framework directed towards the achievement of our goal: price stability. One
particular focus of our monetary analysis is the low-frequency trend in money and credit
developments and the associated emergence of imbalances. This focus allows us both to
assess risks to price stability in the medium to long term and, simultaneously, to embed
some implicit leaning against excessive money, credit and asset price growth in our interest
rate decisions.
As part of our strategic decision to enhance monetary analysis,12 the ECB has conducted
research looking at monetary and credit developments so as to better understand their
impact on macroeconomic outcomes. Interaction with asset price dynamics plays an
important role in this work.13 Increasingly, the results of this research are being integrated
into our regular assessment of monetary developments, which is one source of input for our
policy decisions.
My understanding is that the importance of monitoring money and credit developments is
generally recognised by central bankers and more and more also by academia. Of course,
recognising their importance does not necessarily simplify the task of interpreting those
developments. Experience has shown that ongoing financial innovation complicates the
interpretation of the monetary data. This remains a substantial practical challenge - but one
that must be addressed. Making the analysis of money and credit developments operational
is a key area for new research.
A year ago, here at Jackson Hole, Tobias Adrian and Hyun Song Shin argued that structural
changes to the financial system require the definition of new monetary indicators.14 There
has recently been a focus on the build-up of leverage within the financial sector, through
loans between banks and loans to various special-purpose financing vehicles, some of which
may be located offshore. This kind of approach forms part of the comprehensive assessment
of monetary developments undertaken at the ECB, which extends well beyond the
monitoring of headline aggregates.15 We recognise that considerable progress still needs to
be made. However, overall, our maintenance of both the statistical basis for monetary
analysis and the necessary staff expertise at a time when the value of such work was being
very much called into question has, in my view, helped us significantly in taking important
decisions in recent years.16
Taking everything into account, I would say that we feel encouraged to continue relying on
our two-pillar strategy, noting that considerable further progress still needs to be made in
various areas of research that are part of our enhancement of monetary analysis.17
Credibility, alertness and steady-handedness
I will now turn to my second topic: the effectiveness of interest rate decisions. Even in the
face of the exceptional challenges of recent years, the standard interest rate instrument has
remained a crucial component of the central bank armoury as regards monetary policy.
Our interest rate decisions should be judged on their effectiveness, understood as the
contribution they make to the achievement of the ECB's objective of maintaining price
stability. Effectiveness requires that policy decisions be transmitted to the economy, so as to
influence private price-setting behaviour and thus developments in the price level. In this
respect, understanding the transmission mechanism of monetary policy is crucial. There is a
considerable amount of academic literature in this area,18 to which researchers at the ECB
have contributed in important ways.19
In this literature, it is widely recognised that households and firms' spending decisions are
affected by longer-term interest rates, rather than the very short-term rates steered in
monetary policy operations. Moreover - especially in a bank-based financial system, such as
that of the euro area - many borrowers' decisions are influenced by bank lending rates,
rather than market rates. Consequently, in order to be effective, policy rate changes must
influence rates at longer maturities and be passed through to rates on bank loans.
Viewed from this perspective, conferring a degree of persistence on developments in policy
rates may be crucial.20 A central bank with a reputation for implementing persistent interest
rate changes will be able to convince market participants that an initial interest rate change
will be maintained for some time and/or followed by additional changes in the same direction.
Such expectations will have a strong, immediate impact on the money market yield curve at
longer maturities, since money market rates are largely determined by expectations of future
policy rates. Persistent policy changes are also more likely to affect bank lending rates, since
a persistent rate change is more likely to be passed through. Both channels will allow the
effectiveness of changes in the policy rate to be enhanced.21
Of course, when taking our decisions, we are not mechanically bound by such observations
on monetary policy, despite the intellectual elegance of the underlying models. Nevertheless,
I can recognise the pattern of the ECB's interest rate decisions in this stylised
characterisation. The lower-frequency component of the interest rate cycle - which is driven
by long-lasting or persistent developments in policy rates - influences economic behaviour
and, ultimately, the evolution of price developments much more than the high-frequency
component associated with the exact timing and magnitude of any one policy decision.
Whether interest rates increase by 25 or 50 basis points in one month or another is less
important than our ability to steer the longer-maturity rates of relevance to spending
decisions. While the former may dominate ECB watchers' commentaries, it is the latter that
gives us the leverage to stabilise longer-term inflation expectations and fulfil our mandate.
With this consideration in mind, our approach has often been characterised as
"steadyhanded". The ECB has acquired a reputation for moving interest rates in a steady and
persistent fashion over time. This is a conscious choice. Such deliberate and persistent
moves strengthen transmission, thereby proving effective in achieving our objective of price
stability.
When a central bank enjoys a reputation for implementing monetary policy in a
steadyhanded fashion, private sector expectations of future interest rates will move in a manner
consistent with policy-makers' intentions at all maturities in response to a policy
announcement or measure. As a result, changes in policy rates will have significantly larger
effects on aggregate demand and future price developments than would otherwise be the
case. By implication, less extreme changes in policy interest rates will be necessary in order
to achieve our goal. Our reputation for steady-handed - and thus effective - policy action will
be bolstered. And more effective policy action will contribute to a successful track record in
terms of meeting our objective, thereby delivering price stability.
An effective monetary policy need not, therefore, be an "activist" monetary policy, at least to
the extent that activism is understood to imply significant immediate changes to policy rates
in response to individual pieces of short-term economic "news". While a central bank must
always be ready to act in response to shocks that threaten price stability, a steady-handed
approach, involving a modest initial change in policy rates followed by further moves in the
same direction, may prove more effective. Therefore, criticising a central bank that is acting
with a steady hand for being "behind the curve" rather misses the point: a gradualist
approach of this kind may be the most effective antidote to the threat to price stability.
These considerations are all fairly general in nature. Yet they become especially important if
policy rates threaten to become constrained by a lower bound. Even if the policy rate were to
be constrained in this way, "flattening the yield curve" by reducing longer-term interest rates
would ease monetary conditions if the outlook for price developments required it.22 In this
context, the ability to signal the persistence of policy rate changes is particularly valuable.
That being said, I have always stressed that steady-handedness should not be confused with
lethargy, incapacity or an unwillingness to act. If the risks to price stability over the medium
term change significantly, it is incumbent upon the central bank to ensure that its monetary
policy stance is adjusted immediately, in order to address this change in the assessment of
risk. Policy-makers must always be ready to act promptly and decisively when this is required
by a change in the situation. Delay for its own sake is never a good basis for policy
decisions.
Choosing whether to change policy rates requires permanent alertness. If a new threat to
price stability emerges, this must be identified promptly. Policy action can then be taken to
ensure the achievement of the central bank's objective. However, in deciding how to adjust
the policy stance in order to achieve this goal, conferring persistence on the policy rate may
be desirable, to the extent that this maintains and strengthens transmission.
How should such persistence be communicated? Signalling the persistence of a policy
change by stating that the new level of policy rates will be maintained "come what may" is
problematic. An unconditional commitment of this kind runs directly counter to the need to
maintain the flexibility to act in response to changing conditions in the future.23 A statement
of this kind will either (a) undesirably constrain the ability to respond to new circumstances as
they emerge, or (b) simply be ignored when a new shock occurs. In the case of the former,
the policy stance will not be appropriate and price stability will be placed at risk. In the case
of the latter, the reputation and credibility of the central bank will suffer: its communication
will be ineffective. Neither outcome is desirable. This argumentation forms the basis for my
oft-repeated statement at the ECB's monthly press conferences to the effect that the
Governing Council "never precommits".24
At the same time, avoiding any unconditional commitments does not mean that one cannot
communicate as regards the policy outlook. On the contrary, it means making a fundamental
statement, namely that future decisions will be guided only by the assessment of risks to
price stability, without having to announce the level or path of policy interest rates foreseen
over the coming months.
There appears to be a puzzle here. At first sight, the need to maintain a readiness to act in
the face of changing circumstances appears to run counter to the need for
steadyhandedness in policy decisions. How can one always stand ready to change policy rates to
contain new threats to price stability while simultaneously maintaining a reputation for
conferring persistence on developments in interest rates?
As I argued on a previous occasion here at Jackson Hole, to understand this apparent
paradox, we have to assemble not two, but three building blocks providing insight into the
ECB's conduct of monetary policy.25
•
First, policy decisions focus on the maintenance of price stability over the medium
term. This supports our credibility, understood in terms of the solid anchoring of
private medium and longer-term inflation expectations at levels consistent with price
stability.
•
Second, we behave in a steady-handed manner, conferring persistence on
developments in short-term interest rates so as to strengthen the transmission of
monetary policy.
•
And third, we are never precommitted as regards the future level or path of policy
rates. On the contrary, policy rates are always conditional on the evolution of the
outlook for price developments. We thereby remain alert and maintain a
comprehensive and up-to-date assessment of the economic environment and are
always ready to act decisively and promptly if the need arises in order to achieve our
objective.
Credibility helps to understand the interplay between alertness - i.e., in particular, the
absence of any precommitment - and steady-handedness. It means that there are no
question marks regarding the capacity to act with full independence if and when this
becomes necessary. It therefore allows a central bank's interest rate decisions to have the
maximum impact, whatever the circumstances, and helps a central bank to achieve its goal -
i.e. price stability - with a satisfactory degree of economy of means. Even more importantly,
because credibility consolidates the anchoring of inflation expectations, the interplay between
steadiness and alertness is self-reinforcing. A posture of permanent alertness relying on the
ongoing vigilance of the central bank strengthens the solidity of the anchoring of inflation
expectations. And in this perspective, steady-handedness itself appears to be both a
consequence as well as a cause of the better anchoring of inflation expectations. Not
surprisingly, the anchoring of inflation expectations appears to be at the centre of a "virtuous
self-reinforcing triangle", the vertices of which are credibility, alertness and
steadyhandedness.
A stance of credible alertness is, in my view, one of the most important features of monetary
policy in "normal times" - to the extent that the concept of "normal times" has a meaning for
central bankers! It is even more useful when we suddenly encounter very exceptional
circumstances, as has been the case since mid-2007 and especially since September 2008.
The features of such exceptional circumstances are not only that they occur largely
unexpectedly or that they make inference based on past observations inadequate, but also
that the complex intertwining of economic relationships characterising this turbulent period
can hardly be captured by our mostly linear models. These are times in which the "flap of a
butterfly's wings" causes tornadoes (chaos theory).26 Quickly recognizing the limitations of
our analytical tools during these episodes is essential in order to avoid making inappropriate
decisions.
One can identify three important reasons for "heightened alertness" in periods of turbulence
of the "Lorenzian" type. Firstly, to the extent that very small initial changes are capable of
triggering extremely large changes after a sufficient period of time, it is essential to quickly
establish a lucid diagnosis and swiftly take the decisions necessary to avoid as much as
possible adverse future developments.
Secondly, a common feature in the development of highly turbulent episodes is that central
banks have to cope with abnormally rapid modifications in the economic and financial
environment. These changes might be highly unexpected, erratic and trigger abrupt changes
in the risks to price stability. In such exceptional circumstances, credible alertness is vital,
and swift decision-making should not be hampered by ex ante considerations other than the
delivery of price stability, and, by way of consequence, the anchoring of inflation expectations
is of the essence.
Indeed - and this is the third reason - the risk of unanchoring inflation expectations, whether
upward or downward, is particularly acute in such circumstances. Thus, it is all the more
important to make very clear to markets that, ex ante, they can always map the expected
path of the policy rates relative to the evolution of macroeconomic conditions on the basis of
the unambiguous goal of very solidly anchoring inflation expectations.
Some of these points can be illustrated in the context of the recent financial turmoil. Let us
take the decision to increase rates in July 2008, 11 months after the turbulence began in
August 2007. This decision was criticised ex post by some people, particluarly following the
intensification of the crisis in mid-September 2008, two and a half months after our decision. I
take it that in the perspective of credible alertness, it has been an important and opportune
decision. The risks to price stability had increased significantly by the end of the first half of
2008. Perhaps paradoxically in a period of financial turbulence, we also saw medium-term
inflation expectations beginning to rise, signalling a serious risk of the unanchoring of these
expectations. Our decision demonstrated our determination to continue solidly anchoring
inflation expectations including in the turbulent circumstances that we had to cope with. This
demonstration of alertness proved extremely useful in the period that followed, after
midSeptember, when we had to guard against both deflationary risks in the short term and
inflationary risks in the medium and longer term.
After the acute intensification of the crisis (and following the reduction of the ECB's policy
rates in October 2008), nominal yields at two and three-year maturities fell in the euro area,
as shown in Figure 1. This partly reflected private expectations that the cut in policy rates
would prove persistent. At the same time, as revealed by the developments in break-even
rates illustrated in private expectations regarding euro area inflation remained
Figure 2,
correctly anchored, even at these relatively short horizons. By implication, real rates at such
maturities fell substantially, as shown in Figure 3. To the extent that real rates are the
relevant determinant of private spending - as canonical models of transmission would
suggest - the evidence points to significant monetary easing in the euro area. This very
significant monetary easing was made possible by changes to the policy rate that were of a
magnitude permitting us not to run into lower-bound constraints.27
Of course, extracting relevant information from financial market prices - as is implicit in these
charts - is particularly difficult at times of market turmoil, when liquidity premia and
safehaven effects may be larger than normal. Such caveats imply a need for caution when
interpreting these developments.28 Nonetheless, the evidence supports the view that a
central bank's ability to ease monetary conditions - and thereby support the stabilisation of
inflation and output - is significantly enhanced by its ability to anchor private expectations.
The effectiveness of the ECB's interest rate decisions is reflected in the continued credibility
of the ECB's monetary policy. Notwithstanding the substantial economic and financial shocks
experienced recently in the euro area, longer-term private inflation expectations have
remained securely anchored at levels consistent with price stability. By way of illustration, the
average private inflation forecast at the six to ten-year horizon (as collated by Consensus
Economics) was 1.9% in June 2009. Ten-year break-even inflation rates derived from
indexed bonds also hovered at levels just below 2% (see Figure 4). Even at the peak of the
crisis, there was no discernible doubt that the ECB would maintain price stability over the
medium to longer term.
That being said, it must be stressed that there are at least two important reasons why
deflationary risks in the euro area and in other economies have been smaller than in the
United States. Firstly, the US economy was at the epicentre of the dramatic intensification of
the global financial crisis in mid-September last year, and the nature and magnitude of the
real economic shocks it had to cope with were formidable. Secondly, the flexibility of the US
economy - which is one of its major assets in many respects - also means that very
significant price movements, including downward movements, are more conceivable than in
many other economies, including the euro area.
I am profoundly convinced that, in these dramatic circumstances, central banks in general,
and particularly those on either side of the Atlantic, have demonstrated remarkable unity of
purpose and equally remarkable effectiveness in highly adverse circumstances. They did not
necessarily take the same decisions, because they were not in the same situation as already
pointed out.29 Also to be mentioned in this respect are the significant differences between the
financial structures of the two economies, as highlighted in Figure 5.
Non-standard measures: Enhanced credit support
I will now turn to the third element of my remarks, concerning the ECB's enhanced credit
support. At times of turmoil and stress - when conventional channels for the transmission of
monetary policy are blocked or impaired - central banks may need to act, possibly forcefully,
so as to ensure that their policy decisions remain effective.
Our non-standard measures should be viewed in this light. We define "enhanced credit
support" as meaning the special and primarily bank-based measures that are being taken to
enhance the flow of credit above and beyond what could be achieved through policy interest
rate reductions alone. These measures were introduced to complement the reduction of
interest rates, with the aim of ensuring that the easing of financial conditions triggered by
policy rate cuts was fully transmitted to firms and households at a time of turmoil when
financial markets and institutions were not functioning normally.
When significant tensions first emerged in the money market in early August 2007, the ECB
was in the vanguard of moves to address the problem. More specifically, on 9 August -
within hours of the tensions first becoming apparent - we conducted a special liquidity
operation, providing €95 billion to the market that same day. Other special operations
followed in subsequent days. Thus, the ECB was the first central bank to engage in
nonstandard measures in response to the turmoil. The response was significant and rapid. Better
evidence of the ECB's alertness and readiness to act would be hard to find.
Since then, we have adopted various other non-standard measures with the aim of
maintaining the flow of credit to households and companies. These non-standard measures
represent our policy of enhanced credit support for the euro area. There are five main
elements of this approach:30 the introduction of full allotment at fixed rates in the provision of
central bank liquidity via Eurosystem operations; the lengthening of the maturity of our
operations, which now extend up to one-year operations; the further expansion of the list of
assets that we accept as collateral in our operations; the provision of liquidity in foreign
currencies, notably US dollars provided by the Federal Reserve; and finally, the purchase of
€60 billion of covered bank bonds in order to revive this market segment, which is important
in Europe.
I would like to highlight in this context the very close cooperation that has been established
between central banks. Without such trustful cooperation, global events could have been
much more dramatic. This is particularly true for the period following the intensification of the
crisis in mid-September 2008. Being in Jackson Hole, it is natural for me to mention very
warmly the link established between the Federal Reserve and the ECB to supply foreign
exchange on both sides of the Atlantic. In my view, this cooperation played a very important
role in stabilising European financial markets.
The set of measures described above has fundamentally eased banks' liquidity constraints in
the euro area, thereby supporting the extension of credit and the rolling over of maturing
loans, even in challenging market conditions. One distinguishing feature of these
nonstandard measures is their focus on the banking system, reflecting the bank-centric structure
of the financial sector in the euro area (see Figure 5).31
The ECB's approach contributed