Vítor Constâncio: Challenges for euro area monetary policy in early
2018
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the 32nd
International ZinsFORUM, Frankfurt am Main, 6 December 2017.
* * *
The Governing Council of the ECB at its October meeting decided to reduce the rate of monthly
asset purchases. In my remarks today, I would like to explain the rationale behind that decision,
and how it remains consistent with our mandate for price stability.
In short, as our asset holdings rise and the growth outlook improves, unchanged policy
parameters actually imply greater monetary stimulus. Furthermore, I am confident that the
apparent disconnect between growth and inflation is a temporary phenomenon and that inflation
dynamics will increase.
It is therefore possible for us to scale back our net asset purchases, while keeping our policy
sufficiently accommodative to support those inflation dynamics. If one extrapolates from the
current brighter economic outlook, one cannot imagine that we would need to extend further our
present purchases. A symmetric approach to our inflation mission would therefore be more
appropriate than a one-dimensional promise to do more in case of deflation. Managing QExit will
be challenging, however.
While ending the purchase programme quickly could provoke undue market reactions, we should
not overlook the fact that the longer our asset purchase programme continues, the less effective
the programme and the greater the risks attached to it become. Having a credible view of the exit
is important to keep any such risks contained.
The recent policy decision
Let me begin with the adjustments to our monetary policy parameters made in the October
Governing Council meeting. The asset purchase programme will be extended to September
2018, at the lower amount of €30 billion per month, or beyond if necessary, until the Governing
Council sees a sustained adjustment in the path of inflation consistent with its definition of price
stability.
This decision was made in an environment of robust demand growth, but with still modest
increases in the underlying inflation rate. We have now benefited from 18 uninterrupted quarters
of economic growth, with indicators pointing to continued robust growth. The unemployment gap
- an established measure of labour market slack - is now closed, and employment has reached
its highest ever level in the euro area.
In short, our monetary policy has successfully stimulated demand and returned slack resources
into productive use. One would expect this strong demand to generate a marked increase in
inflationary pressures. Yet this has not yet fully materialised in the euro area, although signs of
inflationary pressures and limits to the lags have been constant for the last six month. Why then
have we reduced our purchases before without there being a substantial adjustment in inflation?
The decision to reduce the monthly rate of purchases rests on two factors. The first involves
understanding how the stimulus provided by our asset purchases evolves over time, and the
second relates to the relationship between output and inflation.
The recessions caused by the global financial crisis and the sovereign debt crisis required
significant monetary stimulus to counter the large degree of slack in the economy and ensure
that inflation remained consistent with our price stability definition. Monetary policy also had to
react to a number of headwinds, which reduced the impact of a given level of interest rates on
economic demand.
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Some, such as an ageing population and the slowdown in measured productivity growth, are
longer term in nature. Others were more temporary. The process of deleveraging pushed up
desired saving, uncertainty weighed on investment and a prolonged period of low inflation
threatened to de-anchor inflation expectations, with a risk of outright deflation.
But as the ongoing recovery gains momentum, the influence of these temporary headwinds is
fading. Fears of deflation have dissipated. In these circumstances, unchanged monetary policy
parameters would in fact imply an unwarranted increase in monetary stimulus, and when one
looks at the 10-year German government bond yield since the summer one might conclude that,
despite fewer purchases, we had eased our monetary policy, a step which does not correspond
to our plan.
A further reason why the Governing Council elected to scale back our monthly purchases is that,
as the size of our portfolio increases, the marginal impact of a given level of purchases
increases. Owing to our already large bond holdings, the free float of securities is now
substantially lower than when we began our programme in 2015. This increases the relative
share of our purchases in the market, and therefore the impact of those purchases per billion
euro spent. In other words, a slower pace of purchases today can have an equivalent effect on
yields as a higher pace yesterday.
Moreover, as the stock of bonds rises, our reinvestment needs rise in tandem and we have to
increase our gross purchases - that is, our net purchases plus our reinvestments; and do that in
an environment of lower new borrowing in most euro area countries. This means that, even with
a slower pace of net purchases, the Eurosystem will still have a substantial presence in the
market. Indeed, cumulative redemptions of around €150 billion are expected in 2018.
For all these reasons, an adjustment to our policy stance was necessary at our last meeting. By
the same logic, we should be able to further adjust our policy in the future as confidence
increases about the robustness of the recovery without choking off growth or inflation. And the
more the recovery advances, the less the economy depends on unconventional monetary policy
stimulus and benefits from balance sheets repair, structural reforms and fiscal tailwinds.
As for the current rate of inflation, it is worth noting that the euro area is by no means the only
developed economy exhibiting robust output growth with inflation rates below historical
experience. I do not have time today to do justice to all the various explanations put forward by
economists. In truth, I'm not particularly persuaded by any of them. I do not believe that such
factors will prevent us from achieving our mandate over the medium term. We may take a little
longer to achieve our objective, but achieve it we will.
Let me focus on just one explanation - that the relationship between domestic slack and inflation,
termed the Phillips curve, has become so flat that changes in output have little effect on inflation.
Prolonged periods of low inflation can reduce wage growth, since wage-setters pay some
attention to past outturns. Moreover, job insecurity, digitalisation and high unemployment have
encouraged unions to prioritise employment over wages. And the deep downturn has led to
broader slack in the labour market - i.e. involuntary part-time and temporary work - that needs to
be reabsorbed before wage pressures rise.
Yet we are going through a transition phase out of a very deep crisis, and these downward forces
should wane. Indeed, the difference between the headline unemployment rate and broader
measures of labour market slack has already edged down in the past two years. The share of
firms that say that labour shortages are limiting their production is at its highest level ever in
manufacturing and services. This is translating into higher wage growth now, and in turn
contributing to a pick-up in inflation. Various measures of underlying inflation, which is key for
assessing durability, appear to have turned a corner.
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I say "appear", because policymakers should be humble in their pronouncements. Estimates of
the degree of slack in the economy vary widely and are often revised. Model outputs, however
complex they may be, should be treated with due caution, and judgement based on experience
remains an essential part of the policymaking process. We should avoid making unwarranted
statements about points in time too far into the future over which we have little true visibility.
It also means that policy decisions not only should be based on the most likely outcome
predicted by models, but should also take into account the balance of risks. There are times
when the risk of inaction far outstrips the risk of action, and the prudent course is to act with
vigour. Introducing asset purchases to stave off the risk of deflation is one recent example. But
there are also times when the balance of risks lies in the opposite direction, and prudence
dictates that policymakers should be more circumspect.
Future challenges for monetary policy
On that note, while I believe that the forces already at work should in due course bring an end to
the need for asset purchases, it is a matter for the ECB's Governing Council to decide on the
exact timing of such a move. Our approach should evolve in tandem with our improved
expectations for developments in the real economy and ensure that our mandate for price
stability is fulfilled over the medium term.
Let me instead spend a few moments considering some of the risks we face in implementing our
policy over the coming years. I should also add at this point that these risks are likely to grow the
longer our asset purchase programme continues.
The first risk relates to the subsiding deflationary headwinds I have already mentioned. Could it
be that our current monetary setting is suddenly too accommodative? In short, because of the
uncertainties and imprecisions involved in measuring slack and inflationary pressures in the
economy, we might find ourselves behind the curve without realising it. Hence, through the long
and variable lags of monetary policy, we will end up with inflation above the rate consistent with
our price stability mandate.
This would require a sharp correction of the monetary policy settings in years to come. Yet such
a correction of interest rates would pose risks to the financial sector. Banks could be hit hard as
funding costs rise faster than interest income on outstanding loans.
The second risk is a related one, in that these factors could have already unwound, and inflation
could turn out much higher than we expect over the course of 2018. We would find ourselves
behind the curve - and realise it - but the optimal monetary policy response would involve us
having to adjust our forward guidance.
This forward guidance was put in place to stabilise market expectations and to enhance the
effectiveness of our asset purchases. This is because we indicate that interest rates will rise
only when we are "well past" the horizon for asset purchases. So prolonging asset purchases
pushes out market expectations of the first rate rise, depressing interest rate expectations
across the curve. Of course, the effectiveness of that guidance also relies on market beliefs of
our future actions.
In effect, forward guidance is a promise not to react to data outturns in the future so as to
persuade markets to maintain low expectations for interest rates. But if we offer guidance that
extends too far into the distance, beyond the point where we can form reasonable expectations
about the economy, it risks unduly tying our hands unless this is backed by unanimity in the
Governing Council.
This is a particular risk at present when, as I described earlier, any future increase in interest
rates needs to be gradual, and hence moving late could result in policy remaining too loose for
too long. Certainly as the time comes to reconsider our monetary policy stance during the course
of 2018, we should reflect at length on the degree to which we wish to pre-commit ourselves.
Risks to monetary policy extend beyond the immediate outlook for inflation. Our policies have
reduced the spread over risk-free interest rates paid by households and firms for their borrowing,
and unblocked the flow of credit to the real economy. Such spreads are at their lowest ever level.
Yet reduced spreads may encourage investment in businesses that are only profitable at low
interest rates, and such loans risk turning sour as interest rates rise. Indeed, banks and investors
may be tempted to "search for yield", without being adequately recompensed for the risk they are
taking on. The normal place for monetary policy is not at the long end of the yield curve, but at the
short end.
The focus of monetary policy is of course on our price stability mandate, and ensuring financial
stability risks are adequately mitigated is the role of microprudential supervision and
macroprudential policy. While there is little evidence at present of area-wide credit-fuelled
bubbles, there are some notable localised pockets, such as in commercial real estate, and
evidence of "search for yield" behaviour.
The financial crisis showed how such risks can interfere with the smooth operation of monetary
policy through their effects on banks, which remain a key part of the monetary transmission
mechanism in the euro area. We should therefore bear in mind that these risks could potentially
complicate our ability to meet our price stability mandate in the future.
There are other longer-term risks to monetary policy, namely through the allocation of credit to
both productive and unproductive firms. By reducing interest rates for all firms, monetary policy
may indirectly permit inefficient firms to remain in business - becoming so-called zombie firms.
This blunts the productivity-enhancing function of downturns to bring about "creative destruction",
whereby inefficient firms are forced out of business, freeing up resources to move to more
efficient firms and boosting aggregate productivity. Indeed, there is evidence that creative
3
destruction was weaker during the Great Recession than in previous downturns and that
4
zombie firms have weighed on productivity growth in some euro area countries.
Productivity growth plays an important role in raising aggregate living standards, but it also
affects the conduct of monetary policy. Higher productivity growth spurs investment, and
expectations of higher future income encourage households to spend more today. Thus slower
productivity growth requires monetary policy to lower interest rates by more than would otherwise
be the case to stimulate the economy. Given that interest rates are currently low, and our stock
of purchases is quite large, this would restrict our ability to respond to future downward shocks.
What I have just explained are the economic risks arising from a potential misallocation between
productive and unproductive businesses brought about by our asset purchases. But there are
also legal risks for the ECB regarding our Treaty obligations. Article 127 requires that we "act in
accordance with the principle of an open market economy ... favouring an efficient allocation of
resources". Thus, in respecting our price stability mandate, we should only do as much as is
necessary, and be aware of potential side effects from running expansive policy for too long.
An important principle of an open market economy is price formation in markets through the
interaction of private sector agents. It should be those interactions that ensure correct pricing,
notably of credit risk, and not the interactions created by our asset purchases.
It is clear that, with the Eurosystem now owning public and private sector assets amounting to
over €2 trillion, we have become a bigger player in the market than ever before. This means that
we are now buying bonds from more price-insensitive investors, such as pension funds and
insurance companies, bidding up the price at which we need to pay. Liquidity conditions are
expected to become more challenging in certain market segments the longer the purchasing
programme remains active.
As such, we have to be mindful not to exert an undue influence on price formation.
Another potential complication relates to our public sector purchases. A key safeguard that we
have set up for these purchases is to operate so-called "blackout periods", where we do not buy
around the date of a new issuance. This facilitates price formation and ensures that Article 123 of
the Treaty is fully respected - the monetary financing prohibition.
Mindful of self-imposed constraints in this respect the remaining space for both net and gross
purchases will largely be in newly issued bonds. This poses some potential complications that
we have to monitor very closely.
Conclusion
Let me conclude.
The recovery in the euro area continues at a robust pace, employment has risen strongly. Both
wages and underlying inflation appear to have turned the corner.
At its October meeting, the Governing Council chose to reduce the rate of net asset purchases,
which, as I have explained today, prevented an unwarranted increase in monetary stimulus. We
will continue to monitor developments in the economy and set policy in a way that is consistent
with our price stability mandate.
In doing so, we must also take into account the balance of risks when setting policy.
If we withdraw our monetary policy stimulus too early and too fast, asset prices could drop and
yields rise sharply, with negative spill-over effects to the economy. At the same time, we have to
be mindful, as our asset purchase programme continues, that the risks attached to it may
increase the longer it lasts. Nourishing a market belief that the exit might be permanently
postponed could exacerbate the potential cliff effects. A credible perspective on exit is needed to
keep these risks contained.
A sense of proportion will therefore be crucial in managing the QExit.
1
See, e.g., Gordon, R. (2016), The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil
War, Princeton University Press. It is worth noting that others contest the slowdown, arguing it relates to
measurement error, e.g. Brynjolfsson, E. and A. McAfee (2011), Race Against The Machine: How the Digital
Revolution is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the
Economy, Digital Frontier Press.
2
See Mersch, Y. (2017), "Economic Policy and the Need for Humility", speech at the Conference "Banking and
Financial Regulation", Bocconi University, 9 October.
3
Bartelsman, E., López-Garcia, P. & G. Presidente, "Cyclical and structural variation in resource reallocation in
Europe", mimeo.
4
See, e.g. See Gopinath et al. (2015): "Capital Allocation and Productivity in South Europe", NBER Working Paper
No. 21453; Borio et al. (2016): "Labour reallocation and productivity dynamics: financial causes, real
consequences," Bank for International Settlements Working Papers 534; Andrews, D. & F. Petroulakis (2017),
"Breaking the shackles: Zombie firms, weak banks and depressed restructuring in Europe", OECD Economics
Working Papers No.1433.