Erkki Liikanen: Eurosystem's monetary policy and its transmission
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland, at the Rotman ICPM Forum,
Helsinki, 5 October 2015.
* * *
Accompanying slides (PDF) can be found on the Bank of Finland's website.
[Slide 1: Title page]
Welcome
[Slide 2: Agenda]
[Slide 3: I - Eurosystem's Expanded Asset Purchase Programme (EAPP): Background]
[Slide 4: Decisive action by the Eurosystem stabilised financial markets]
The financial crisis created great uncertainty and increased challenges from the monetary
policy-making. Not just the Eurosystem but central banks around the world reacted by cutting
policy rates, increasing their banking system's liquidity and adopting so-called non-standard
measures of monetary policy.
In July 2012 the President of the ECB, Mario Draghi, committed to do "whatever it takes to
preserve euro". This came to mark a turning point for the crisis: markets calmed down and
fears of euro area breaking down were removed.
During the same month, in its monetary policy meeting, the ECB's Governing Council cut the
main policy rate to below 1 percent, and the deposit rate to zero. By mid-2014 all crisis
countries apart from Greece were again able to borrow from private markets.
[Side 5: Traditional monetary policy restricted by the ZLB]
Despite stabilisation of the financial markets, the operating environment of monetary policy
remained challenging. Inflation and expected inflation continued to slow down and short term
money market rates increased, which meant that further monetary policy easing was needed
to maintain price stability over the medium term.
The policy rate is, indeed, the most straightforward tool the central bank has to steer market
interest rates. By 2014 we, the Governing Council, had cut the policy rates almost to zero. The
deposit rate was cut to negative in the June 2014 policy meeting.
The sheer existence of a lower bound for policy rates complicates monetary policy decision
making as it creates asymmetry: A central bank can always increase its policy rate to control
inflation but the policy rate cut is limited by the zero bound even if inflation drops to very low
levels.
[Slide 6: Real interest rates increase if inflation expectations fall]
The zero lower bound creates a challenge, as falling inflation puts upward pressure on real
interest rates. It is the real interest rates, and expectations of them - not the central bank's
policy rate - that has the ultimate impact on household consumption or firm investment
decisions.
Increasing real interest rates thus indicated that further monetary easing was necessary
despite the policy rates being close to the zero lower bound.
[Slide 7: Eurosystem's accommodative monetary policy]
In the June 2014 monetary policy meeting, the Governing Council eased the stance of
monetary policy. As a part of the package, we cut the deposit rate to negative, extended the
guarantee of banks' access to unlimited central bank finance (given that they provide sufficient
collateral) by extending fixed rate full allotment policy, and we set up a series of additional
long-term refinancing operations that provide the banks with finance on the condition that they
increase the value of their loans to the real economy.
The current cycle of monetary policy easing started in October 2014 when we introduced two
private sector asset purchase programmes: the asset backed securities purchase programme
and the third programme for covered bonds.
In January 2015 the Governing Council judged that additional monetary policy easing was
needed as the inflation outlook weakened further. The Eurosystem extended its purchases to
bonds issued by euro area governments, government agencies and European institutions.
[Slide 8: II - Key features of EAPP]
Let us now discuss the current, expanded asset purchase programme, in more detail.
[Slide 9: The Eurosystem sets the liquidity of the euro area banking system]
The Eurosystem is able to regulate the euro area banking system's liquidity with two tools.
Firstly, the Eurosystem organises regular refinancing operations: tenders. The interest rate
applied to these operations is the main policy rate, which currently stands at 0.05%. With these
refinancing operations the Eurosystem steers short-term money market rates. The tender
operations are demand driven: banks can decide whether or not to participate.
In contrast, outright asset purchases are not demand driven. By asset purchases the central
bank actively steers liquidity of the banking sector by bond purchases.
Participants of regular tender operations consist of monetary policy counterparties, mainly
banks. Outright purchases reach directly a much broader set of financial institutions, some of
which are not even located within the euro area.
As instruments bought by the Eurosystem may have maturity of up to 30 years, with these
purchases the Eurosystem is able to steer longer term interest rates.
[Slide 10: EAPP consists of two parts]
The Eurosystem's asset purchase programme consists of two parts.
The first one is the private sector purchasing programme. In this programme the Eurosystem
purchases covered bonds and asset backed securities issued in the euro area both from
primary issuance and secondary markets.
The second part is the public sector purchase programme, PSPP. Under this programme the
Eurosystem buys bonds only from the secondary market.
[Slide 11: Key features of the programme]
The monthly size of purchases is 60 bn. euros. This includes ABSs, covered bonds and public
sector bonds.
The Governing Council stated in January that purchases 'are intended to be carried out until
end-September 2016 and will in any case be conducted until we see a sustained adjustment
in the path of inflation which is consistent with our aim of achieving inflation rates below, but
close to, 2% over the medium term.'
With this forward guidance, we, i.e. the Governing Council, indicated that our commitment to
the accommodative monetary policy to align inflation with the price stability objective was the
key component of our January decisions.
The organisation of the programme inside the Eurosystem is such that the ECB co-ordinates
the programme but national central banks conduct the purchases. According to this division of
labour, the national central banks buy domestic bonds. For example, the Bank of Finland buys
Finnish government bonds from a broad range of financial institutions. The size of each
country's purchases are calculated via the country's capital key. This parameter reflects the
relative population and output of each euro country. As a result, the Bank of Finland purchases,
on average, about 700 million euros worth of public sector bonds each month.
In order to minimise market disturbances, the Eurosystem participates in securities lending.
Purchases extend from short, 2 years, maturities to very long ones, up to 30 years.
[Slide 12: III - Impact EAPP]
[Slide 13: Transmission of central banks' asset purchase programmes]
The Eurosystem buys securities with newly issued central bank money. The Eurosystem's
balance sheet expands, and liquidity of the banking system increases.
The impact of asset purchases transmits to output and inflation via the financial markets: yield
curves, lending rates, asset prices and exchange rates. Financial market prices react rapidly,
but output and prices only gradually over time.
[Slide 14: Implementation of EAPP has been smooth. "It is a marathon"]
This slide presents all outright asset purchase programmes of the Eurosystem, including those
that are no longer active. The current expanded asset purchase programme started off
smoothly and purchases followed the agreed plan. As you can see, purchases of bonds in
particular have increased the Eurosystem's balance sheet.
If the EAPP is compared with a marathon, we now have 15 km behind us.
[Slide 15: EAPP affects inflation and output via several channels]
In what follows I will focus on four main channels via which the purchase program transmits to
the real economy. These channels are: the expectations channel; the signalling channel; the
portfolio balance channel; and the exchange rate channel.
[Slide 16: 1. Expectations: First impact, immediate intraday movements in asset prices
on 22 January]
Financial markets expected already in the second half of 2014 that the Eurosystem would
expand its purchases to public sector bonds. Despite this, financial markets reacted strongly
to the Governing Council's announcement on 22 January to the launch of bond purchases.
Stock indices increased by a percentage, euro depreciated against the US dollar by 1.4% and
yields of Spanish and German government bonds fell by 0.25 percentage points. The market
response was comparable on 5 March when the Governing Council, at its monetary policy
meeting, announced further details of the programme and that purchases would commence
almost immediately.
The Governing Council's announcement exceeded market participants' expectations, which
was a positive surprise shock to the markets.
[Slide 17: 2. Signalling: Forward guidance is an integral part of EAPP]
Already in 2013 the Governing Council employed forward guidance to reduce expectations of
an early exit from accommodative monetary policy. The Governing Council said explicitly that
interest rates would be kept 'at present or lower levels for an extended period of time'.
The asset purchase programme signalled itself a continuation of accommodative monetary
policy. This was further amplified by the Governing Council's forward guidance. If markets were
to interpret the asset purchases as just a temporary measure, it would not bring about a
broadbased decline in long-term interest rates.
The Governing Council has stated 3 September 2015 that the EAPP is intended to be carried
out until end-September 2016, or beyond, if necessary, and in any case, until we see a
sustained adjustment in the path of inflation that is consistent with our aim of achieving inflation
rates below, but close to, 2% over the medium term.
[Slide 18: Signalling: Money market rates expected to remain low]
Forward guidance has been credible in a sense that expectations on money market rates
remain low well into the future. The money market rates are expected to remain zero at least
until 2017.
[Slide 19: 2. Signaling: Transmission of low policy rates to provision of credit has
improved]
Further increase in accommodative monetary policy by asset purchases has worked itself
through banks' retail interest rates. Since the announcement of the purchase programme, the
average interest rates of new corporate loan agreements have kept falling, especially in GIIPS
countries. As banks' expectations on the Eurosystem's monetary policy stance eased, the
money market interest rates fell. For example, the 12-month Euribor declined by almost 50
basis points since mid-2014, to 0.15%. Almost 60 % of euro area corporate loans are linked to
Euribor rates.
[Slide 20: 3. Portfolio balance: Share prices have increased, recently increase in
volatility]
The portfolio balance channel broadens the effects of asset purchases to the whole financial
system. If a central bank purchases long-term debt securities, the average duration of debt
securities on the market decreases. Narrowing of the yield spread encourages investors to
purchase bonds with even longer maturities, and long-term bond yields decline further.
Investors will also have to look for substitutes for government bonds they sell to the
Eurosystem. Rebalancing investment portfolios is reflected in corporate bond yields and
equities. A decline in yield of corporate bonds reduces funding costs and encourages
investments. A rise in securities prices increases the wealth of securities holders and thus
consumption.
[Slide 21: Portfolio balance: Effects of EAPP on pension funds]
In the short run, a bond purchase programme lowers yields and increases the value of asset
classes such as stocks. Therefore, effectiveness of the portfolio channel depends partly on the
ability of investors to sell their sovereign bond holdings to the Eurosystem and invest in other
securities.
This is an issue that might be challenging to institutional investors such as pension funds, as
rules limit their ability to invest in riskier assets. On the other hand, search for yield and higher
returns might make some investors to take on excessive risk.
Central banks' asset purchase programmes are not the only reason for the globally low interest
rate environment. In any case, medium term profitability of pension funds may be challenging
in the low interest rate environment. For those companies that have in past made contracts
with high return guarantees, the low interest rate environment is particularly difficult.
The ultimate aim of the Eurosystem's asset buying programme is to support economic activity
and contribute to a sustained return of inflation towards the price level target. Weak nominal
growth is globally a key source of risks to financial stability. In the long run, sustainable
economic growth is a prerequisite of a sound pension system.
Finally, it is worth noting that financial sector risks cannot be eliminated by monetary policy.
Macroprudential policy is needed to promote financial stability. It is conducted by national
bodies and by pan-European institutions such as the ESRB, European Systemic Risk Board.
In September, the board published a report on systemic risks in the EU insurance sector,
including those originating from low interest rate environment.
[Slide 22: EA governments bonds make 24 % of insurance companies' and pension
funds' assets]
Government bonds and other fixed-income assets represent a large share of all assets of euro
area insurance companies and pension funds. Government bonds alone account for 24% of
the assets. The rest are diversified across various asset classes.
[Slide 23: Exchange rate: The fall in EUR/USD since mid-2014 reflects policy divergence]
The Eurosystem's asset purchase programme, as well as divergence in monetary policy
stance, have weakened the exchange rate of euro. Firstly, the increased supply of euros
relative to other currencies lowers the exchange rate. Secondly, many institutional investors
may have considered the US and UK government bonds as substitutes for bonds of high-rated
euro area countries. Demand for other currencies leads to depreciation of euro. The nominal
exchange rate of euro has depreciated by 8 % since January 2015.
However, the purchase programme is not the only reason for the weakening euro. In addition,
economic growth, inflation and interest rates are higher in the US than in euro area.
[Slide 24: Actual and expected inflation trended down before the EAPP decision; since
then, the probability of deflation has declined]
The impacts of the purchase program that I have mentioned so far - expectations, interest
rates and exchange rates - are elements of the transmission mechanism of monetary policy.
The ultimate aim is price stability. The Eurosystem's purchasing programme has played a
crucial role in reducing the probability of deflation as perceived by financial market participants.
[Slide 25: Renewed decline in oil prices have put downward pressure on prices]
Most recently, the main reason behind sluggish inflation has been the decline in the price of
oil. It has put strong downward pressure on inflation globally. The ECB's policy actions and
improved confidence have been key factors supporting inflation expectations in the euro area.
[Slide 26: Lending volumes have improved]
The effects of the accommodative monetary are being felt in bank loan developments. The
growth of loans to the private sector has been positive from the beginning of the purchase
programme. Investment activity has increased in euro area on average, and private sector
confidence has strengthened.
[Slide 27: ECB staff projections in September]
The ECB's latest staff forecast from September indicates a continued, though somewhat
weaker recovery in the euro area. Mainly due to the global uncertainties -- especially the
slowdown in China and the moderation in world trade -- growth projections were revised
downwards from June. Increase in inflation is also slower than expected. We monitor all
relevant information. And we are ready to act, if warranted. We recall that the programme
provides flexibility in terms of adjusting the size, composition and duration of it.
[Slide 28: Thank you!]