Euro area monetary policy: where we stand
Speech by Yves Mersch, Member of the Executive Board of the ECB,
28. Internationales ZinsFORUM 2013: Zinsen 2014
Frankfurt, 9 December 2013
Ladies and gentlemen,
Following on from our last monetary policy meeting in 2013, I’d like to take this opportunity to assess where we stand.
I’ll begin by explaining our current economic situation and monetary policy, and I’ll then discuss some of the issues that have emerged from the public debate on the risks and side effects of this policy over the past year.
Finally, I’ll look at how much scope we still have, given current low interest rates, to maintain price stability in the euro area.
Economic situation and current monetary policy
Let me begin by giving my assessment of the economic situation.
The euro area is on a long and arduous road to recovery.
We expect the economy to shrink by 0.4% in real terms this year compared with last year, but next year we’re forecasting the first positive real growth since 2011, at 1.1%, rising to 1.5% in 2015.
Our inflation forecast remains very modest.
We expect consumer prices to have risen by 1.4% in the euro area this year, but by only 1.1% next year, when one-off inflationary factors will likely cease to apply. We are then forecasting a small rise in inflation to 1.3% in 2015, as a result of the continued economic recovery.
So what are the implications of this economic outlook in terms of monetary policy?
The European treaties give the ECB a clear mandate to maintain price stability. And the ECB has defined this task in terms of an ambitious target which has applied for over ten years: to maintain inflation rates below, but close to, 2% over the medium term.
Monetary policy takes a long time to feed through to macroeconomic indicators such as inflation and growth, so the ECB has to take a forward-looking and continual approach.
It is also important to avoid knee-jerk reactions when inflation falls below the 2% mark, as it now has. Instead, we should ensure that price developments don’t divert us in the longer term from our quantitative definition of price stability, for example if clear inflationary or deflationary trends were to make themselves felt across the euro area.
At the moment, though, the downside risks are the main focus of debate. The Governing Council of the ECB considers the risks to price developments to be broadly balanced.
At the beginning of November, we took a series of monetary policy measures to limit the downside risks. As things stand, it may take longer than usual for monetary policy to have an impact on inflation and growth, in which case we will face a longer period of low inflation.
However, I believe it is important not to confuse this with a deflationary scenario, which would apply only if prices were to fall over a prolonged period, i.e. over several quarters, and on a broad front. There are currently no signs of this being the case.
All in all, we believe that central bank interest rates will remain at or below current levels for a significant period, again assuming that the expected inflationary profile doesn’t change.
Low interest rates
Against this background of low interest rates, savers are unhappy because they get very low returns on specific fixed-interest investments, and they partly blame the ECB for this.
I understand that savers are concerned about their returns, but it is also important to clarify the options and role of monetary policy, and what it can and cannot do.
Its influence on the real returns of different types of savings is limited. Real-term interest rates and thus the real returns on savings are the result of medium- to long-term economic trends that are beyond the influence of monetary policy. “Natural” real-term interest rates reflect the economy’s long-term production potential. What this essentially means is that if the euro area is to achieve higher growth, and thus higher real returns, it needs to become more competitive again.
This debate was recently revived by the former US Treasury Secretary Larry Summers. He said that because people were saving too much in industrial nations with ageing populations, negative interest rates would restore the economic equilibrium over the long term: if natural real rates remained permanently below zero, investment and savings would level out.
This is a highly pessimistic, even fatalistic view. Natural real rates are not God-given: they depend on the economy’s potential long-term productivity, which can be increased only by making structural reforms and encouraging companies to invest and develop innovative products.
Monetary policy can merely have a smoothing effect on this trend by limiting economic growth to prevent inflationary overheating as well as recessions and crisis situations which can trigger a deflationary spiral.
So we shouldn’t overestimate the influence of monetary policy on real long-term interest rates, which simply reflect factors in the real economy.
But we have to ask the question of whether a long period of excessively low rates can bring risks of its own. Economic theory and empirical practice show that rates that are “too low for too long” may result in the underpricing of risk on the securities markets, and such distortions create false incentives which can result in asset price bubbles.
Excessively long periods of low rates can also help banks to survive when they technically shouldn’t be able to. We have seen this happen in Japan. If banks are to continue doing their job of providing the economy with credit after a banking crisis, they need to clean up their balance sheets.
We are very much aware of the risks of a long period of low interest, and if the worst comes to the worst and there is a risk of imbalances and distortions creeping in to the macro economy, the regulatory authorities must take market-specific measures to prevent them. Prudential action such as anti-cyclical capital buffers for banks can limit financial market risk and help to ensure that our monetary policy has the desired effect.
The banking union can also play a valuable part in reducing the likelihood of future crises. This includes the comprehensive assessment of significant euro area banks which has just begun.
Likewise, governments and businesses can help to achieve sustainable economic growth, most importantly by taking advantage of low interest rates to invest in productivity.
Investment and competitiveness
Euro area investment rates are still relatively low, and not just in the countries worst affected by the crisis.
So why are people not investing more, especially in countries which can afford to do so? After all, sustainable investment will help to consolidate the delicate economic recovery taking place in the euro area.
It is the job of companies to invest, but they will only do this if they believe the investments will pay for themselves and they have access to the financial resources they require.
Europe needs a healthy banking sector if capital is to be available for productive investment. Our comprehensive assessment of the euro area’s most significant banks is a step in the right direction, because we will identify any weaknesses, and recommend ways of remedying these and emerging stronger from the exercise. Many banks are already making preparations so they have to take fewer corrective measures after the assessment.
The creation of a banking union is necessary in order to repair the credit channel and improve financing conditions for companies. But this alone is not enough.
Structural change is needed to reduce dependence on bank credit, particularly among small and medium-sized businesses. Three changes are needed here.
First, we need a broader and deeper capital market in Europe. Currently, euro area businesses still obtain 80% of their financing via the bank channel, whereas the situation is practically the opposite in the United States, with 80% of company financing being obtained through the capital markets. The key problem here is that the European capital market continues to be fragmented along national lines.
Second, the European securitisation market needs to be revived as it can form a bridge between small companies’ limited direct access to capital markets and banks’ need to avoid cluster risks as well as institutional investors’ demand for appropriate products.
Third, the regulatory provisions should take into account the fact that European asset-backed securities did not suffer any widespread losses. It therefore does not follow that the painful experience with subprime mortgage-backed securities in the United States should be built into the regulatory capital requirements in Europe.
Whether an investment is “worth it” depends partly on a healthy business environment and partly on economic policy. Governments can create positive incentives by creating a favourable climate for investment, for example by reducing barriers to entry for new businesses and opening up protected sectors.
Public investment in key areas like education and infrastructure can also make markets more attractive to private investors by improving the conditions for businesses. However, this is easier said than done in a period of consolidation and deleveraging. It is all the more important, therefore, that the regulatory framework does not create barriers – particularly for long-term investment projects based on partnerships between the public and private sectors.
Good financial and economic policy can also clarify the intentions of individual countries and the euro area as a whole, and provide the level of security investors require before entering the market. Corporate bank deposits are at a healthy level in the euro area, and surpluses could be used to invest in increased production.
Monetary policy options in 2014
These considerations show that a sustainable and dynamic economic recovery is dependent on political measures that are well beyond the scope of monetary policy.
As the central bank, the only contribution we can make – and it’s an important one – is to continue to maintain price stability. This creates a strong foundation, so that market players and governments can focus on investment and reforms without having to worry about inflation or deflation. And, even though there is still some uncertainty regarding how everything will interact, our technical preparations are largely complete.
Let me mention some of the other monetary policy options that are open to us, though I hope you will understand that no final decisions have been made.
I’m not announcing future measures, but simply illustrating that we have plenty of tools at our disposal, and will use them if necessary.
Allow me to mention just three possible measures, which are currently being widely discussed. Of course, our options are not limited to these:
first, reduce the deposit facility rate below zero;
second, carry out more longer-term refinancing operations;
third, purchase securities directly.
If we reduced the deposit facility rate to below 0%, this would probably put additional downward pressure on overall rates, though it is difficult to predict how much. But it could also increase the incentive to consume and invest, and create additional impetus for economic recovery.
One positive side effect could be a redistribution of resources within the European financial system that would boost the economy. Some euro area banks currently have a high level of surplus liquidity which they deposit with the ECB.
A negative interest rate on the deposit facility could lead banks to reallocate their surplus liquidity. Instead of hoarding money with the central bank at negative rates, it would be more attractive to pump additional credit into the economy.
However, there are very few precedents for this, so it is difficult to quantify the positive effects, and it would have costs of its own.
First, instead of resulting in increased lending, it could lead to increased cash holdings. Cash would “earn” zero interest rather than a negative nominal rate, but it still wouldn’t find its way into the economy.
A negative deposit facility rate would also make banks less profitable, because it would cost them money to have surplus liquidity. Of course, the purpose of monetary policy is not in itself to make banks profitable, but there is a risk that they would pass on the additional cost to their customers by reducing the interest on deposits and making borrowing more expensive, both of which would defeat the object of the measure.
What about the second, much debated option of increasing the availability of longer-term refinancing?
Longer-term ECB loans make it easier for banks to plan ahead, as they have to refinance a smaller portion of their liabilities at any given time. In an ideal world, they would pass this benefit on to the economy as a whole by increasing their own longer-term lending – and there are indications that the ECB’s three-year refinancing operations in late 2011 and early 2012 did have such an effect. 
But longer-term refinancing also has its own risks and side effects. Banks don’t just pass on the additional funds to companies and households: they also use them to expand their government bond portfolios. In countries with fiscal problems, this strengthens the vicious cycle of excessive government debt and fragile banks.
The problem could be partly solved by tying central bank lending to specific purposes, such as financing companies in the euro area.
But this would require the ECB to make normative judgements about which uses of resources it supports and which it rejects, which would represent large-scale interference in the market.
However, it would be possible to intervene in the markets for specific securities. Some countries have experience with this in the form of quantitative easing (QE).
The purpose of QE is to directly influence long-term interest rates, whereas our standard range of monetary policy measures seeks to influence them indirectly. If we cut headline rates, banks can obtain cheaper refinancing, which they then typically pass on to other sectors with longer-term liabilities.
But there are also situations in which these standard measures do not work, either because headline rates cannot go any lower or because the banking system doesn’t pass on the benefits. In theory, purchasing programmes can help because they bypass the banking system.
In the classic version of QE, the central bank buys government bonds to maintain an expansionary monetary policy, even when headline rates are at or close to zero.
This is what Japan, the United States and the United Kingdom have done. The ECB Statute also provides for the direct purchase of securities on the secondary market, but the euro area has no central government whose debt the ECB could buy. It could acquire defined portfolios of euro area Member States’ government bonds, but this would pose immense economic, legal and political challenges.
The direct purchase of private securities also poses risks. In particular, it exposes the central bank to increased balance sheet risk. If we provide banks with liquidity, we lend central bank money and require collateral in return. The direct purchase of securities, on the other hand, is usually uncollateralised.
Moreover, the central bank could be accused of transferring private risk to the public sector, which ultimately is borne by the taxpayer.
Again, the problem is that the central bank must decide which assets to buy and at what price. Having these decisions made by a central body goes against the principle of the free market economy.
Friedrich August von Hayek said that only the free market could factor all the relevant information into the price and thus ensure a meaningful allocation of assets. He accused social engineers who planned society on the drawing board of displaying a “pretence of knowledge”.
Only in exceptional circumstances can direct purchases of securities by the central bank correct a failure of the market. It is normally preferable for all market players to establish suitable prices.
So to summarise, the euro area is staging a gradual recovery. Providing there are no unforeseen shocks, we will be back into positive growth from next year.
If any further monetary policy measures need to be taken, we do have them at our disposal. What is important is that all actors – banks, companies, households, governments and regulators – play their respective roles in a responsible manner.
The primary objective of monetary policy is to keep long-term inflation expectations stable, even if prices are rising slowly for a period. With its mandate of price stability, the ECB can be relied on to achieve this.
See, for example, Darracq-Paries, M. and De Santis, R., “A non-standard monetary policy shock: the ECB’s 3-year LTROs and the shift in credit supply”, Working Paper Series, No 1508, ECB, January 2013.