Benoît Coeuré: The transmission of the ECB's monetary policy in
standard and non-standard times
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank, at
the workshop "Monetary policy in non-standard times", Frankfurt am Main, 11 September 2017.
* * *
1
Monetary policy has had a powerful impact on financial markets in recent years. There is
compelling international evidence that non-standard policy measures, such as asset purchases,
forward guidance and negative interest rates, have been successful in altering relative asset
prices in a way that is consistent with the predictions of portfolio rebalancing theory and the
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signalling channel of monetary policy. Few therefore dispute that the first stage of transmission
of non-standard policy measures to the financing conditions of the private sector has been
effective. Since the effective lower bound on nominal interest rates is expected to prevail more
often in the future, this is undoubtedly good news.
The situation is less clear, however, when it comes to the second and third stages of
transmission - that is, from easier financial conditions to economic activity and from economic
activity to prices. Many central bank observers point to continued anaemic growth and low
inflation across the globe and conclude that unconventional policy measures have failed to
stimulate the economy. If this were the case, it would place a question mark over the use of such
measures.
In my remarks this morning I would like to examine this claim more closely. In doing so, I will
focus on two prime channels underlying the second stage of transmission: the exchange rate
channel and the real interest rate channel. My remarks will therefore be neither exhaustive nor
complete, given that monetary policy can affect the economy through many other channels as
well, such as its impact on the valuation of equities and, hence, on firms' cost of capital and
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investment decisions, Tobin's q in short. Another channel of relevance is the bank lending
channel as formalised by Bernanke and Gertler (1995).
But by focusing on the exchange rate and interest rate channels, we can get a good
understanding of how effective recent policy measures have been. In particular, I will show that
monetary policy-induced exchange rate movements may have considerable impact on
consumer prices, but that this relationship depends on the state of the economy and the shocks
driving it, much in line with the recent literature in this field. And I will show that the New
Keynesian Investment and Savings (IS) curve is alive and well in the euro area - that is,
aggregate demand responds to changes in real ex ante interest rates, and can also be shown to
have done so in recent times, provided it is measured properly.
A state-dependent exchange rate pass-through
Let me start with the exchange rate channel - a channel that has been heavily debated in recent
months in the light of the large movements that we have observed in the foreign exchange
market. For example, since the beginning of April the euro has appreciated by around 13%
against the US dollar and 7% in nominal effective terms. Textbook economics would suggest that
such sizeable changes ought to lower the prices of imported goods and thereby put downward
pressure on producer and consumer prices.
On the left-hand side of slide 1 you can see that there is indeed a strong correlation between
annual changes in the euro's nominal effective exchange rate and annual extra-euro area import
price inflation, here shown for consumer goods excluding food, beverages and tobacco. Simple
eyeballing would suggest a pass-through of around 40%, at least following depreciations, a point I
will return to later. On the right-hand side you can see that the correlation is already much
weaker in the case of the pass-through to producer and consumer prices. No discernible pattern
emerges over the past seven years or so.
Of course, the reduced responsiveness at higher stages of the pricing chain in part reflects the
fact that imports only account for a fraction of both producers' overall input costs and final
consumption. But the seemingly stubborn resilience of consumer and producer price inflation to
the sharp depreciation of the euro in 2014, and the subsequent appreciation in 2015, is
nevertheless surprising. After all, based on prevailing estimates in the literature, the net effect of
these two opposing exchange rate movements could have lifted HICP excluding energy and
unprocessed food inflation - I will refer to this as core inflation from now on - by up to 0.5
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percentage point over the course of last year. In other words, such estimates suggest that euro
area core inflation in 2016 would have been less than half its actual level if it had not been for the
euro's depreciation in the preceding years.
While this cannot be ruled out in the absence of a reliable counterfactual, it at least invites
suspicion, not least as producer price inflation proved equally resilient lately. Recent price
developments therefore raise two important questions. First, has the exchange rate
passthrough declined over time and, if so, is it a temporary or a more permanent phenomenon. And,
second, if it has declined, is this related to the use of non-standard monetary policy measures?
My answer to the first question is that, yes, the pass-through is likely to have been lower in recent
years, mainly for two reasons.
The first, and more permanent, reason has to do with structural factors unrelated to monetary
policy. A large body of the literature illustrates that the exchange rate pass-through depends on
factors such as the monetary policy framework, import composition, trade integration, currency
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invoicing and the rise of global value chains. Broadly speaking, as globalisation has advanced
and inflation and inflation volatility have declined, these factors have contributed to progressively
reduce the exchange rate pass-through in most developed economies. For example, in the case
of the euro area, it has been found that a growing share of local currency pricing has
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mechanically reduced the pass-through. You can see this on slide 2 for the euro area. Today
the pass-through to final consumer price inflation may be less than a third of what it was at the
beginning of the century.
The second reason is more cyclical in nature. It relates to the state of the economy and the
response of monetary policy to it. The theory is that exporters will not set their prices as a
constant mark-up over costs, but will adjust them to expected changes in their future marginal
costs and demand prospects. The implication is that what ultimately matters for the exchange
rate pass-through is the type of shock that is hitting the economy. This notion goes back at least
to Corsetti and Dedola (2005) but has received more prominence lately following the work of
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Kristin Forbes and co-authors (2015).
On the left-hand side of slide 3 you can see initial evidence to support this claim. ECB staff find
that less than half of the euro's exchange rate variations vis-à-vis the US dollar over the past
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almost 20 years was purely exogenous. More often than not, exchange rates move in response
to changes in relative demand, supply or monetary policy. And each of these shocks might entail
a different response from domestic prices.
This you can see on the right-hand side. What this chart shows you is that there are occasions
when euro area core inflation rises, rather than falls, following an exchange rate appreciation -
which is entirely at odds with our traditional thinking on the pass-through. Perhaps unsurprisingly,
this is typically the case when the exchange rate appreciates in response to a favourable
demand shock. The logic is as follows: as the economy operates above capacity, inflationary
pressures emerge that are sufficient to fully offset the disinflationary effects coming from the
exchange rate channel.
The chart also shows that changes in the relative monetary policy stance have, on average, the
expected impact on consumer prices: if euro area policy tightens, the exchange rate appreciates
and inflation falls. In other words, there is no empirical evidence that the exchange rate channel
of monetary policy is inactive.
But its strength will critically depend on the overall state of the economy, and not on the type of
policy measure, standard or non-standard. This is my answer to the second question and can
best be seen by looking at two concrete examples.
The first one relates to the sharp depreciation of the euro in the run-up to the announcement of
the APP. As you can see on slide 4, a simple model-based analysis suggests that a large
fraction of the decline in the euro's external value reflected the worsening economic outlook, to
which we ultimately reacted. It is likely that exporters to the euro area, faced with falling euro area
demand, absorbed part of the exchange rate movement in their mark-ups to protect their market
shares, thereby mitigating the upward pressure on prices stemming from a weaker currency.
The second example relates to the current situation. Slide 4 shows that there are three forces, of
roughly equal strength, that help to explain the euro's marked appreciation in recent months:
improved euro area growth prospects, an exogenous component and a tightening in the relative
monetary policy stance vis-à-vis the United States.
Slide 5 illustrates the implications of this shock decomposition for the assessment of the
exchange rate pass-through. The black line, which is the net effect, suggests relatively mild
downward pressure on core inflation, much below what the rule of thumb would tend to suggest,
despite the sizeable appreciation.
The reason is simple. The current solid economic expansion in the euro area allows firms that
export to the euro area to increase prices in their currency without losing market share, thereby
mitigating, once again, the pass-through. So, exporters to the euro area are now able to recoup
part of the margins they compressed during the downturn. The extent to which they are able to
do so also depends on the degree of competition, a point made by Rudi Dornbusch back in 1987.
The more concentrated market power is, and the less substitutable products are, the more likely
firms are to increase their margins following exchange rate appreciations. This also means that
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the pass-through may well differ across industries.
These examples demonstrate that it is by and large the state of the economy that will determine
the strength of the pass-through. Monetary policy, for its part, is likely to influence the
passthrough predominantly through its impact on the economy itself.
And at the moment this support from monetary policy may be even more powerful than in the
past. The reason is that, in the class of models used here, positive demand shocks are normally
identified by assuming that short-term interest rates rise in response to higher growth and
inflation.
At the current juncture, however, the policy-relevant horizon - the "medium term" concept in our
monetary policy strategy - is likely to be longer given the persistence of subdued inflationary
pressures. Our forward guidance on both policy rates and the APP, as reiterated by the
Governing Council last Thursday, reflects this assessment. This means that, compared with
past demand shocks, policy will remain more accommodative for longer, thereby likely muting
further the pass-through of any growth-driven exchange rate appreciation. And with the current
recovery in the euro area being largely driven by domestic demand, euro strength may also have
less of an impact on growth than, for example, after the Great Financial Crisis.
All of this suggests, therefore, that monetary policy never acts in isolation on the exchange rate
and that, in periods of recovery, the positive confidence and stimulus effects of monetary policy
are likely to offset, at least in part, the disinflationary effects of a stronger currency coming from
expectations of tighter policy.
Of course, this also means that should the contributions of the different shocks driving the
exchange rate change over time, then also our assessment of the impact on inflation will have to
change - expansion or not. Exogenous shocks to the exchange rate, if persistent, can lead to an
unwarranted tightening of financial conditions with undesirable consequences for the inflation
outlook. As shown on slide 6, the emerging disconnect between the euro's exchange rate
vis-àvis the US dollar and the long term interest rate differential between the US and Germany may
suggest that we are entering such a situation. Against this background, the recent volatility in the
exchange rate represents a source of uncertainty which requires monitoring.
The New Keynesian IS curve in the euro area
This brings me to the second channel I would like to discuss this morning: the effects of
monetary policy on real economic activity.
Much of our attention recently has been focused on the properties of the Phillips curve - that it
may be flatter, non-linear or mis-specified in terms of the relevant economic slack. By now, we
are fairly confident that non-linearities and broader labour market slack are likely to explain much
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of the weakness in inflation as of late.
Some observers have interpreted the lack of stronger price pressures as a failure of monetary
policy to stimulate the economy. They argue that persistently low inflation is testimony to the
ineffectiveness of non-standard policy measures. If this were true, then also the reasoning
behind the shock-based exchange rate pass-through would in part be misguided.
I would argue, however, that such claims reflect a serious misunderstanding and simplification of
how monetary policy works. There are very few instances, such as through the exchange rate,
where policy can directly affect prices. In most cases monetary policy transmits to prices
through its impact on the intertemporal allocation of consumption, savings and investment. If
prices are slow to adjust, a cut in the key policy rate lowers the real interest rate, which, in turn,
stimulates interest-sensitive spending. In other words, if we want to see if policy works or not, or
if the economy has become less sensitive to changes in interest rates, then we should examine
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the slope of the IS curve, and not only of the Phillips curve.
Empirical research on the IS curve is scarce, however. And the few studies available are
generally not encouraging from a monetary policy perspective. They typically find that output
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does not respond, in a statistically significant way, to the real interest rate. Often they even find
a positive relationship between real interest rates and output. These findings are at best
disturbing given that much of mainstream monetary thinking is built on the idea that firms and
households take the level of the interest rate into account when making economic decisions.
To illustrate the empirical failure of the IS curve, slide 7, column 1, shows the estimated
coefficients of a regression of the euro area output gap on its own lag and a measure of the real
"interest rate gap", i.e. the difference between the real ex ante interest rate and the time-varying
natural rate. Except for the fact that output is not forward-looking - I will come to this in a minute
- this is a standard New Keynesian IS curve where the output gap is based on estimates by the
European Commission, the short-term interest rate is the three-month Euribor, expected inflation
is taken from the ECB's Survey of Professional Forecasters (SPF) and the natural rate is taken
from the euro area estimates by Holston, Laubach and Williams (2016).
Clearly, the real interest rate gap is not statistically significant at any reasonable confidence level.
This finding holds true if we use actual ex post inflation - specification 2 - instead of expected
inflation, or if we include the real interest rate per se, and not as a deviation from the natural rate,
as is sometimes suggested, as in specification 3.
The financial crisis and the use of non-standard policy measures do not seem to explain the
puzzle either: the real interest rate remains insignificant if we restrict the sample to the period
before the outbreak of the crisis, specification 4, or if we take the euro area shadow rate as
estimated by Wu and Xia (2016) - specification 5 - a measure that attempts to mimic the joint
effects of unconventional policy measures at the zero-lower bound.
What I would argue, however, is that the short-term interest rate is not the appropriate measure
to use in an empirical IS curve. In a bank-based economy, such as the euro area, the short-term
interest rate may simply not be sufficient to characterise the monetary policy stance and, hence,
the financial conditions ultimately determining the decisions by households and firms. The
imperfect substitutability between market-based financing and bank loans was already
recognised by Modigliani (1963) and later refined by Bernanke and Blinder (1988).
Indeed, it is enough to recall the period after the outbreak of the sovereign debt crisis, and the
associated financial fragmentation, to see that the interbank market rate is a biased measure of
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the financing conditions facing the private sector. In other words, unless there is a perfect
transmission from changes in short-term rates to the ultimately relevant borrowing rates,
estimates using the former will yield inconclusive results.
This conjecture is also supported by the data. In specification 6 we replaced the short-term
interest rate with a measure of the composite bank-based cost of borrowing for non-financial
firms. If we use this measure instead, the real ex ante interest gap in our IS curve has the
expected sign and becomes statistically significant at the 10% level: a 1 percentage point
reduction in the gap increases output by 0.13 percentage point.
The interest rate channel becomes even more powerful once we estimate a New Keynesian
IScurve that is closer to first principles - that is, one that is also forward-looking in output, as in
specification 7. For this purpose, we add to the equation the expected real GDP growth rate six
quarters ahead, as collected by the ECB's SPF.
As in previous findings in the literature, output appears to be strongly forward-looking. But the
thing to note is that the real interest rate gap is now significant at the 1% level, suggesting an
increase in output by 0.3 percentage point following a 1 percentage point drop in the real rate
gap. There is also no evidence that output might have become less sensitive to changes in real
bank lending rates with the advent of non-standard measures: although the sample is naturally
small, and estimates might therefore be biased, specification 8 illustrates that the coefficients
remain unchanged when we estimate the same forward-looking IS curve for a sample starting
with the outbreak of the sovereign debt crisis in 2010.
In other words, these estimates would suggest that about a quarter of the reduction in the output
gap that we have observed since the introduction of our credit easing measures in June 2014
can be directly explained by the impact of our measures on bank lending rates, even after
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controlling for the indirect positive impact on expected inflation. These estimates are very close
to other internal ECB staff estimates, using more sophisticated term structure and general
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equilibrium models, of the impact of our measures on economic growth.
So, monetary policy is far from being ineffective in stimulating aggregate demand, also when
approaching the effective lower bound. The fact that inflation remains subdued rather reflects
constraints operating at the third stage of transmission - from activity to prices - that are often
outside the control of monetary policy.
Before I conclude I would like to illustrate one last point. Bank lending rates are without doubt a
key variable in explaining output movements in the euro area. The evidence I provided today
further emphasises this point. At the same time, the financial conditions that are ultimately
relevant for firms and households may be broader than that. One of them - the exchange rate - I
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discussed in more detail earlier in my remarks. Other factors may include equity prices or
17
long-term interest rates that are often relevant for household mortgages.
One way to summarise these factors is to use financial conditions indexes (FCIs). My colleague
Peter Praet gave a detailed speech on such indices earlier this year, which I strongly
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recommend reading. Here I would like to focus on the relevance of these broad measures for
economic activity.
As you can see in column 9 of slide 7, FCIs are highly statistically significant when used in a New
Keynesian IS curve. This is unlikely to be a statistical artefact. It is rather further evidence that we
cannot reduce our analysis of the impact of monetary policy to a simple short-term rate as has
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typically been done in the academic literature so far.
The question then is no longer which financial variable to use in estimations, but how to weigh
them to reflect any varying impact they may have on output and, ultimately, inflation. For
example, my last specification on slide 7 uses an FCI that attributes a much larger weight to the
exchange rate, in line with the rule of thumb I mentioned earlier, which suggested a strong
passthrough to inflation. Interestingly, this FCI fits the data less well, and is just about significant at the
10% level, which might support the view that the exchange rate pass-through could be lower than
what such a rule of thumb would suggest.
But as I explained earlier, even a lower weight on the exchange rate would likely not fully capture
the relative importance of the various financial variables at each point in time. That is, if the
impact of changes in financial conditions on inflation depends on the state of the economy, then
ideally FCIs would be based on time-varying weights. This is food for thought for future research.
Conclusion
With this in mind, let me conclude.
The negative relationship between the real interest rate gap and economic activity as posited by
Wicksell back in 1898 is a mainstay of modern central banking. This relationship has not been
lost with the advent of unconventional monetary policy measures. By easing market-based
financial conditions, and by putting downward pressure on the real interest rate that banks
charge to borrowers, central banks can stimulate aggregate demand, even when short-term
interest rates approach the effective lower bound.
The validity of this relationship is also crucial for assessing the price effects of monetary
policyinduced movements of the exchange rate. With policy being effective in boosting growth, any
disinflationary effect of a stronger currency arising from expectations of a tighter future monetary
policy stance might be mitigated, or offset, by the ensuing improvement in the economic outlook.
However, exogenous shocks to the exchange rate, if persistent, can lead to an unwarranted
tightening of financial conditions with undesirable consequences for the inflation outlook.
Thank you.
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Andrade et al. (2016) and Blattner and Joyce (2016).
3
Rising stock prices might also trigger wealth effects on consumption (see e.g. Modigliani, 1971).
4
See, e.g., Landau and Skudelny (2009).
5
See e.g. Taylor (2000), Campa and Goldberg (2008), Gust et al. (2010), Gopinath et al. (2010), Ahmed et al.
(2015), Georgiadis et al. (2017) and di Mauro et al. (2008).
6
See ECB (2016).
7
For more recent work related to the euro area see Comunale and Kunovac (2017).
8
Exogenous shocks are often associated with changes in the risk premium (see e.g. Engel and West, 2010).
9
See e.g. Hahn (2007) and Osbat and Wagner (2006).
10
See e.g. Coeuré (2017) and Draghi (2017).
11
Phillips curve estimates are often partial equilibrium in nature, building on single equation specifications. Of
course, because output and pricing decisions are taken simultaneously, both the IS and the Phillips curve are
equally relevant and should therefore ideally be analysed in a general equilibrium model, such as in Smets and
Wouters (2007).
12
See e.g. Fuhrer and Rudebusch (2004), Stracca (2017) and references therein.
13
See also Al-Eyd and Pelin Berkmen (2013) and Blattner and Swarbrick (2017).
14
The real bank rate gap has fallen by around 1.6 percentage point since the second quarter of 2014. The output
gap has fallen by around 2.1 percentage point over the same period.
15
See, e.g., Draghi (2015).
16
In empirical open economy extensions of the New Keynesian model, the exchange rate appears as an
additional variable in the IS curve (see e.g. Ball, 1998, and Svensson, 2000).
17
Fuhrer and Moore (1995) show that the correlation between short-term rates and output reflected the fact that the
statistical properties of the short rate were similar to that of the long rate, which should ultimately matter for
aggregate demand.
18
See Praet (2017).
19
This is similar in spirit to the findings of Meltzer (1999) and Goodhart and Hofmann (2005) that changes in the
real monetary base exert separate effects on aggregate demand and that the addition of other asset prices can
explain the real interest rate puzzle.