Peter Praet: How does monetary policy secure price stability over
the medium term?
Intervention by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the 4th European Technical Consumer Goods Retail Summit, Berlin, 30 March 2017.
* * *
The origin of the global financial crisis
In 2008 the global economy faced a calamity unparalleled since the Second World War. The
crisis had been preceded by a mood of over-optimism in several advanced economies.
Expectations about future income were at odds with slowing underlying growth, giving rise to an
"expectations gap". In the euro area, expectations were reinforced by a revived sense of
economic prosperity that was associated with the introduction of monetary union. Firms were
borrowing against their future income expectations in some countries; households and
governments were doing likewise in other countries. Also, considerable financial liberalisation
and deregulation had taken place which made debt accumulation easier. In the euro area, this
was compounded by increased financial integration which led to a substantial rise in intra-euro
area cross-border flows. As banks acted as intermediaries in both debtor and creditor countries,
they too had become overexposed.
When the cycle did turn, central banks were confronted with a multifaceted and pernicious
challenge. The "expectations gap" had left a number of economic agents overindebted and in
need of balance sheet repair. Overextended banks needed to deleverage. And with this, a
socalled balance sheet recession ensued.
Monetary policy responses to the crisis
The euro area crisis evolved in three main phases, each of which required a different monetary
policy response.
The first phase was an abrupt liquidity crisis triggered by the turning of the global financial cycle
and the subsequent collapse of Lehman Brothers. Banks suddenly became very uncertain about
the underlying health of other banks and stopped lending to each other. Consequently, global
central banks stepped in with forceful and coordinated interventions to provide essential liquidity
to the banking sector. Without this response, the financial system would have collapsed and a far
deeper recession would have occurred.
This phase of the crisis had profound effects on the banking sector - effects which in the euro
area were not addressed as swiftly as in other jurisdictions due to the incompleteness of its
institutional set-up. Sovereigns needed to support their national banking sectors even though they
lacked the fiscal capacity to do so, aggravating the link between banks and governments in the
euro area.
This paved the way for the second phase of the crisis: the sovereign debt crisis and its
amplification through the "bank-sovereign" nexus. As the cost of borrowing for certain
governments increased, banks with exposures to this debt came under intense market pressure,
ultimately leading to entire national banking systems losing market access. This in turn resulted
in financial fragmentation and a serious disruption to the monetary transmission mechanism. In
other words, as the ECB lowered interest rates, these reductions were not being passed on to
firms and households to the same extent in every euro area country.
First, to ensure banks could depend on longer-term funding, central bank liquidity was made
available for up to three years and the list of eligible collateral that could be used to access
central bank money was expanded. This eased the pressure on banks to sell less liquid assets
at depressed prices to access obtain cash, a process which would have rapidly reduced the flow
of credit to the economy.
Second, the announcement of Outright Monetary Transactions (OMT) in 2012 removed the euro
area break-up risk which was being priced into governments' borrowing costs and the severe
economic dislocation that would have occurred. Second, the announcement of Outright Monetary
Transactions (OMT) in 2012 reduced the likelihood of a break-up of the euro area. This risk was
being priced into governments' borrowing costs and would have resulted in severe economic
dislocation. Nonetheless, the sovereign debt crisis left a damaging legacy on the euro area
economy and laid the groundwork for the third phase of the crisis.
In the subsequent years, as the euro area recovery struggled to gain traction, banks in large
parts of the euro area - particularly in vulnerable countries - were engaged in a drawn-out
process of deleveraging their balance sheets on account of the legacy from [impact of] the
second phase of the crisis. In early 2014 the third phase of the crisis started and by that
summer, it was clear that additional monetary policy measures would be required. Inflation had
begun to drift downwards and there was a palpable risk of a self-sustained period of deflation.
As the main policy interest rate, the interest rate on the deposit facility, was already at zero, the
Governing Council needed to introduce new measures to provide additional stimulus to the
economy and steer inflation back to levels below, but close to 2%. To this end, the ECB sought
to affect the range of interest rates which are relevant for private sector financing conditions.
Starting in June 2014, the Governing Council introduced a negative deposit rate of -0.1%, and
reduced it by a further 10 basis points in September 2014. This marked the first round of cuts
into negative territory and was viewed as a way of providing additional stimulus to the economy
as it extended the scope of conventional monetary policy.
Over the same period, a credit easing package was announced which included targeted
longerterm refinancing operations (TLTROs I), a third covered bond purchases programme (CBPP3)
1
and an asset-backed securities purchase programme (ABSPP). The overarching motivation
underpinning the design of this package was twofold. First, to improve the pass-through for each
euro of liquidity injected into the financial system to private sector borrowing costs and second, to
reinforce the accommodative monetary policy stance.
Credit easing measures influence the economy via three main transmission channels: direct
2
pass-through, portfolio rebalancing and signalling. The direct pass-through channel is the most
prominent one. It directly lowers banks borrowing costs, which in turn lower lending rates for
firms and households, and this supports consumption and investment. In the case of the
TLTROs I, which were specifically aimed at encouraging bank lending to the private sector in an
environment of deleveraging, banks were able to borrow at a very favourable interest rate from
the Eurosystem. The cheaper funding costs were intended to increase competition in the market
for bank loans, which would consequently lower borrowing costs for firms and households. For
the CBPP3 and ABSPP, purchases increase the demand for these securities and as a result
lead to higher prices and lower yields. As these securities are backed by loans to firms and
households, the price increase encourages banks to issue more loans so that they can be used
to issue more asset-backed securities and covered bonds. This increase in loan issuance also
fosters competition and lowers borrowing costs for firms and households.
At the beginning of 2015, the inflation outlook had deteriorated and there was an increasing risk of
a too prolonged period of low inflation. As a result, in January 2015 the Governing Council
announced the expanded asset purchase programme (APP), which encompassed the CBPP3
and the ABSPP as well as the introduction of a public sector purchase programme (PSPP). The
monetary stimulus from the PSPP works through several transmission channels, but the most
powerful is via portfolio rebalancing. For example, this can mean that not only the asset prices
increase in market segments where direct purchases occur, but higher prices can also spill over
into non-targeted market segments. This leads to a decline in yields and lowers the cost of
borrowing on capital markets for firms. At the same time, the general compression of yields
across all asset classes incentivises banks to rebalance their portfolios towards assets with
higher risk-adjusted returns, such as loans to firms and households.
Not long after the APP became operational, the Governing Council introduced the second round
of cuts to the deposit interest rate. This decrease into more negative territory meant that the
negative deposit rate was now viewed as an instrument to empower the portfolio rebalancing
channel of the APP, as it incentivised banks to invest the proceeds they received from selling
assets in higher yielding assets.
Overall, these measures have been designed to complement each other and have proved
adaptable and effective to the series of shocks which have buffeted the euro area economy since
their introduction. Indeed, the APP has been recalibrated three times since its introduction and in
March 2016 the Governing Council announced four more targeted longer-term refinancing
operations (TLTROs II) to further support credit availability to euro area firms and households.
The economic impact of monetary policy measures
Our measures are working their way through the financial system and have led to a major easing
of financing conditions for euro area firms and households, benefited credit creation and
contributed to a more robust and sustained economic recovery.
A week ago we conducted the fourth and last operation under the second round of Targeted
Long-term Refinancing Operations (TLTROs), the so-called TLTRO-II, which we announced in
March 2016 as part of an effort to forestall the risks of renewed transmission impairments that
we saw early last year - in the wake of another episode of acute financial instability - and the
consequences that a break-down in bank transmission could have had for price stability in the
euro area. The total amount borrowed under TLTRO-II, EUR 740 billion, has surpassed our
internal expectations by far. Together with its predecessor, TLTRO-I, these instruments were
among the most effective components of the policy package which we have been enacting since
June 2014. The main channel through which they played through to the broad economy has been
the interest rate channel. When the facility was announced in June 2014 the ECB had been
easing its monetary policy stance for almost three years. Yet, despite a reduction of the overnight
interest rate to levels close to zero, banks in a large fraction of the euro area economy had not
been reducing their lending rates at the same pace and, in some countries, in fact they had
tightened credit conditions dramatically. The stimulus was not moving downstream to reach the
real economy.
That trend was reversed almost instantly after the June 2014 announcement. Already over the
summer of 2014 - even before the first operation was allotted in September of that year - lending
rates plunged to levels unseen since 2010. Why did this happen? The new facility gave banks a
long-term source of funding at a very moderate cost on condition that they would lend the funds
on to the economy. This turned up the competitiveness temperature in the market for bank credit
which, up to that point in time, had become polarised between banks with scarce access to
funding and limited capacity to create credit, on the one hand, and banks with normal access to
funding on the other. None of the two types of banks had a capacity or an incentive to provide
credit to the economy on affordable conditions. The new operation put all banks on the same
funding footing and thus created the conditions for the banking industry as a whole to start
competing again for good credit.
As a result of TLTROs and, in due time, the other instruments that were added, bank lending
rates for both firms and households have dropped by more than 110 basis points since 2014 and
are now at historical lows. Encouragingly, the improvement in credit conditions is occurring both
within and across euro area countries. Borrowing costs in vulnerable countries are now
approaching levels observed in the less vulnerable countries. Euro area small and medium-sized
enterprises (SMEs) appear to have particularly benefited from the increasing pass-through of
policy rates. Lending rates on very small loans (below €250,000) have declined by 177 basis
points, and bank lending rates on all non-financial corporation (NFC) loans have declined by 113
basis points.
This sharp decline in bank lending rates has also been accompanied by improvements in access
to credit for firms and households. Bank lending volumes have been on an upward trend. In
January, lending to households recorded its fastest growth rate since May 2011, while corporate
lending, as in the previous month, recorded its highest reading since 2009. Since September
2014, when the first TLTRO was conducted, bank loans to households have increased by 3.8%,
while bank loans to non-financial companies have increased by 3.1%.
As overall financing conditions have eased and credit growth increased, improvements in the
euro area's economic performance have followed. Indeed, the current recovery is showing
considerable resilience, which to a large extent reflects the fact that domestic demand is the
primary driver of growth. At the same time, there are encouraging signs that both global growth
prospects and world trade are strengthening and may well act as tailwinds to further support the
recovery.
Monetary policy is playing a central role in supporting consumption: lower interest rates are
ensuring favourable borrowing conditions and encouraging households to bring forward durable
consumption as well as firms' investment. Consumption of durable goods has rebounded in
recent years, and especially in countries where credit was previously very tight. While investment
has responded more slowly, monetary policy is helping create the conditions for a stronger
investment revival through its overall effect on the economy.
The euro area cyclical recovery is gaining momentum, broadening across sectors and countries.
While the economic outlook is now better than it has been for many years, downside risks
remain, albeit less pronounced than they once were.
The firming of the recovery has not yet translated into a durable strengthening of inflation
dynamics. Headline inflation has increased, but for the most part this reflects rising energy and
food price inflation. Underlying inflation pressures continue to remain subdued. According to our
latest projections, inflation is expected to move towards levels below, but close to, 2% over the
forecast horizon. We are not yet sufficiently confident that inflation will converge to levels
consistent with our aim in a durable manner. Inflation dynamics still remain reliant on the very
substantial degree of monetary accommodation which prevails.
Against this background, the Governing Council has reaffirmed its monetary policy stance,
including its forward guidance, in order to secure a sustained convergence in inflation towards
our aim objective.
1
The first TLTROs took place in September 2014. In September 2014, the ECB announced the launch of the
CBPP3 and the ABSPP.
2
For more details see "The transmission of the ECB's recent non-standard monetary policy measures" ECB
Economic Bulletin, Issue 7/2015.