Maintaining price stability in the euro area
Speech by Vítor Constâncio, Vice-President of the ECB,
at the 18th Annual Central Bank and Investment Authority Seminar organised by Commerzbank,
Berlin, 16 October 2014
Ladies and gentlemen,
Central banking has changed profoundly over the past 7 years. Following the outburst of the global financial crisis, many central banks have been endowed with additional macro-prudential instruments and a more explicit mandate to preserve financial stability. The array of tools used for monetary policy purposes has also increased. While pre-crisis decisions revolved entirely around the setting of a few short-term interest rates, central banks after the crisis have had to become creative and resort to many new types of non-standard monetary policy measures.
At the ECB, the immediate purpose of the non-standard measures adopted at any point in time has been to address specific financial market distortions which prevented a normal transmission of monetary policy decision through normal channels. But, consistently with our mandate, the overarching, ultimate objective of all non-standard measures has always been to maintain price stability over the medium term. As we publicly announced in 1998 and clarified in 2003, price stability in the euro area is to be understood as a year-on-year increase in the harmonized index of consumer prices (HICP) below but close to 2%. It is worth noting that, in the Treaty, our primary mandate is defined in terms of price stability in the market of goods and services and not in terms of asset prices. Furthermore, we have a strictly hierarchical mandate with price stability as our primary goal and without prejudice to this goal, we have to support the objectives of the European Union, notably, output and unemployment stabilisation, as well as financial stability. 
Today, I wish to re-emphasise this property of our decision making. Bearing in mind that the compass provided by our price stability objective is not only important to account for past ECB decisions. It is also essential to understand the current and future course of monetary policy in the euro area, contingent on the various possible scenarios which may prevail in the future.
For this reason, I will start my remarks with a brief overview of past inflation developments in the euro area. My objective is to characterize two broad types of scenarios which can be faced by a central bank. In the first scenario, policy decisions necessarily imply threading a fine line to ensure that any inflationary episodes are short-lived. In the second scenario, monetary policy can be bolder, because a given change in the policy stance will reduce both inflation risks and the slack in the economy.
I will then move on to assess current euro area prospects in the light of such two stylised scenarios. My conclusion is that current conditions are of the second type: inflation is below the ECB’s numerical definition of price stability, and cyclical developments remain sluggish. The expansionary monetary policy measures decided by the Governing Council in the past few months, which I will review next, are a natural implication of these premises.
Recent inflation developments in the euro area
The average inflation rate in the euro area over the 15 years from 1999 to date is 1.96% – a level fully consistent with the ECB’s definition of price stability. We are proud of our track record, that no other central bank shares in modern times and, which was achieved through constant vigilance and monitoring of possible future inflationary threats. Since the outburst of the financial crisis, however, many shocks have contributed to produce non-negligible fluctuations in prices.
HICP inflation fell markedly at the trough of the recession and reached negative levels in the short period between June and October 2009. However, in the second half of 2009, prices started increasing again. HICP inflation climbed rapidly and steadily up to a peak of 3% from September to November 2011. The increase was persistent. Over the 2011-2012 period, HICP inflation was 2.6%, on average. Similar dynamics were observed in the United States, where the average CPI inflation rate between 2011 and 2012 was also 2.6%. Only in Japan was a mild deflation rate of -0.2% recorded over this period.
Euro area and U.S. inflation developments over 2011-2012 occurred at a time of persistently unutilized capacity, and when the unemployment rate had climbed to average levels above 10% and 8%, respectively. This is somewhat puzzling from the perspective of theories suggesting that, ceteris paribus, inflation should fall when there is a large amount of slack in the economy. A possible explanation for these developments, however, is that adverse cyclical conditions were accompanied by a contemporaneous increase in firms’ production costs, which can force a rise in prices and thus contribute to create sluggish demand conditions. The increase in inflation over this period did indeed occur following a rise in energy prices.
We have theoretical and practical experience with shocks of this nature, also called “cost-push” shocks. The oil shocks of the seventies were arguably of this type. Other example of cost-push shocks may be wage increases that are not justified by productivity gains. Cross-country experience shows that these shocks can be challenging for monetary policy, because reducing the duration and the extent of deviations from price stability necessarily comes at the cost of increasing the volatility of real variables. A marginally tighter policy stance will restore price stability more quickly, but at the price of producing temporarily higher unemployment. Conversely, a marginally looser policy stance will avoid an increase in unemployment, but at the cost of producing a more prolonged inflationary episode. The challenge for the central bank is to carefully thread the course of monetary policy that best ensures a return to price stability over the medium term.
In 2011, the Governing Council could have maintained a loose monetary policy stance so as to favour a faster reabsorption of capacity utilisation. With inflation rising towards 3% and also in view of GDP growth rates, that had hovered around 2% in the previous four quarters, the Governing Council decided instead to introduce a preemptive small correction of the monetary policy stance and increased the key ECB rates in 2011.
As of 2012, however, euro area inflation started falling again, and has continued to do so to date, reaching 0.3% in September 2014. Average HICP inflation since January 2013 has edged down to 1%. This is now in contrast not only to the United States, where average inflation over the same period was 1.6%, but also to Japan, where it rose to 1.3%.
Once again, a number of exogenous factors affected price developments, going from food and energy price declines, to the appreciation of the euro against the dollar since mid-2012 to May of this year, and finally to the relative price adjustment that had to happen in the stressed euro area countries. But there are increasing signals that insufficient aggregate demand is also playing an important role.
Following four quarters of moderate expansion, euro area real GDP remained unchanged between the first and second quarters of this year. Survey data available up to September confirm the weakening in the euro area’s growth momentum, while remaining consistent with a modest economic expansion in the second half of the year. The outlook for a moderate recovery in 2015 remains in place, but the recovery continues being dampened by high unemployment and sizeable unutilized capacity. The persistently negative rate of growth of bank loans to the private sector is a particular reason for concern. The annual rate of change of loans to non-financial corporations  remained negative at -2.0% in August, as it continues to reflect the lagged relationship with the business cycle, credit risk, credit supply factors and the ongoing adjustment of financial and non-financial sector balance sheets. The annual growth rate of loans to households  was just 0.5% in August, broadly unchanged since the beginning of 2013.
At the same time, inflation expectations started edging down also over longer horizons. This accentuated the risk that the slack in the economy would become more prolonged with a more persistent effect on inflation.
Further downward developments in inflation expectations would be extremely harmful. With only small scope for further reductions in policy interest rates and persistently timid growth prospects, a low inflation outlook entrenched in the expectations of firms and households would push real interest rate up. Consumers and investors would postpone their expenditure plans and a vicious circle of lower demand and lower prices could ensue.
Lower than expected inflation rates would also be worrisome. They would increase the real value of debt, slowing down the deleveraging process of borrowers, both public and private. The increase of the debt overhang burden would also be detrimental to debt sustainability and to growth. This does not imply any scenario of deflation, in which we do not believe, but depends exclusively on the materialisation of a prolonged period of low inflation and low real growth.
A situation of insufficient aggregate demand accompanied by downward pressure on inflation is a different type of scenario from the one I described earlier. This is a case in which a more expansionary policy stance is not only desirable to reduce the slack in the economy; it also ensures a safer return to price stability over the medium term.
A fortiori, a tightening of monetary policy would be unwarranted.
Nevertheless, an implicit tightening did threaten to occur just over one year ago, when the Federal Reserve announced the tapering of its large-scale asset purchases. In spite of clear Fed communication on the disconnect between this decision and the timing of “lift-off” of policy interest rates, the tapering announcement quickly led to a rise in forward interest rates on both sides of the Atlantic. The ECB’s adoption of forward guidance in July 2013 was largely the result of these unwarranted developments. Recent studies confirm that our forward guidance was successful in reversing the previous increase in forward-rates and in clarifying the accommodative intonation of the ECB policy stance.
However, forward guidance could not to counter the effects of the reduction in the size of the ECB balance sheet that occurred over the past couple of years. Our balance sheet shrunk 30% from a total dimension equal to over 32.5% of GDP in June of 2012 to 19% in May 2014, as a result of banks’ decision to exercise the early repayment option for outstanding 3-year LTROs. This contraction is particularly striking when compared to the balance sheet of the Federal Reserve, which continued expanding from 19% of GDP at the end of 2012 to 25.7% in May 2014. This evolution was accompanied by a similar reduction of the respective monetary bases which means a reduction in the the provision of primary liquidity to the banking sector. Inflation was in 2012 still slightly above 2% and the shrinking of the monetary base was then not a cause of concern.
However, these developments appear to have been jointly interpreted, accordingly with the latest fad in the forex market, as signals that a relative tightening of euro area monetary conditions may be coming over the near future. In turn, these signals contributed to sustain the appreciation in the exchange rate of the euro which, against the U.S. dollar, went from 1.21 in July 2012 to a peak above 1.39 in May 2014, an appreciation of 15%.
It wasin these circumstances, with inflation at 0.5%, that, in June 2014, the Governing Council decided to act.
The measures recently adopted by the Governing Council
A whole package of policy measures was announced in June 2014.
On the side of conventional tools, the ECB cut its monetary policy rate and ventured into negative territory with our deposit facility rate. We reinforced our forward guidance by restating that the key ECB interest rates would remain at low levels for an extended period of time, and that they could fall further if required. We also extended to at least December 2016 our extraordinary regime of providing liquidity at fixed rate full allotment to the banks in our regular operations.
We decided to introduce a new longer term refinancing programme that contains significant differences with respect to our earlier 1-year and 3-year LTROs. First and foremost, the new programme is “targeted”—hence the TLTRO acronym—to provide incentives for banks to channel the newly received central bank liquidity towards the creation of credit to non-financial corporations, including SMEs. As a result, the availability of TLTRO funding up to 4 years for our counterparties is subject to specific conditions related, in the initial phase, to the outstanding stock of credit to the non-financial firms, and subsequently, to the creation of additional net lending of the same type. In both cases, credit to households for home purchases is excluded from the scheme.
A second key difference from the earlier longer-term liquidity provisions is that, subject to the conditions that I have just recalled, TLTROs offer funds until the end of 2018 at a rate that is fixed at 10 basis points over the MRO rate prevailing when the TLTRO is stipulated. Thus, for banks that are not facing vulnerabilities restricting their ability to create loans, TLTROs offer the opportunity to secure very cheap funding conditions for up to four years. Such attractive conditions should increase the banks’ ability to make profits from new lending opportunities. In the absence of additional credit creation, however, banks will have to repay the TLTROs earlier, thus foregoing the benefit of an extended period of cheap funding.
In September we saw the need to reinforce the measures taken in June. This was basically for two reasons: the sudden aggravation of the worrying decline in inflation expectations for all horizons and the release that the economy had surprisingly stagnated in the second quarter. We cut rates again, bringing the rate on the main refinancing operations to 5 basis points and the rate on the deposit facility to –20 basis points. The package of measures announced in September also included two additional non-standard tools in the form of two programmes of private asset purchases, the Asset Backed Securities (ABS) Purchase Programme and the Covered Bond Purchase Programme. These programmes mark the ECB’s determination to exercise a more direct control over the increase in the monetary base, rather than having it passively determined by banks’ demand for our liquidity facilities.
This desire to more actively expand again our balance sheet can be viewed, first, as an additional signal of our policy intentions over the future. It underpins the message that the reduction of the ECB monetary base over the past months, compared to the monetary base of the Federal Reserve, should not be interpreted as the signal of an upcoming policy tightening in the euro area. The recent correction of the exchange rate of the euro against the U.S. dollar, from over 1.39 in May to around 1.26 at the beginning of October and 1.28 today suggests that this signal was well understood.
The new asset purchase programmes will also operate through a portfolio balance channel, as the liquidity directly injected by our purchases can have spillover effects on all types of different assets, from corporate bonds to equity. While the theoretical debate on the exact details of this channel of transmission remains active, empirical analyses of the U.S. experience suggest that the channel does succeed in producing broad effects on inflation and growth. 
Through such broader effects, both programmes should have beneficial effects on firms, thus reducing the incidence of bad loans in the economy, and helping the process of banks’ balance sheet repair. Additionally, the purchase of both ABS senior tranches and Covered Bonds will contribute to a decrease of credit rates as the yields of those securities are closely related with the rates of the underlying loans. Finally, in what regards ABS purchases, the program creates the incentive for new issuances with the potential of supporting a larger volume of credit to the economy as these open banks’ balance sheet space to increase their loan book, namely to SMEs.
The purchase of both types of assets will be surrounded by rigorous conditions and appropriate risk management measures to protect our own balance sheet. ABSs and Covered Bonds to be purchased will have to comply with the same features now in use to accept them as collateral in our monetary operations. This implies that only ABSs with simple structures and transparent underlying assets will be included in the programme. This allows the Eurosystem to perform its own due diligence when assessing the credit risk of each security whose purchase may be considered. Further limits are placed on the amount of each issue that can be bought, or on the amount per issuer. Minimum ratings are necessary in both cases and further conditions ensure broad risk equivalence among all the securities we will purchase. Finally, we will buy only senior ABS tranches and would consider buying mezzanine tranches only if they benefited from an appropriate government guarantee. All these restrictions reduce, of course, the amounts of securities that are potentially available on the market. Nevertheless, the outstanding market value of assets that respect all our restrictions is large: approximately EUR 600 billion for covered bonds and around EUR 400 billion for ABS. We are, of course aware that many present holders of these securities may not be willing to sell and consequentely what we will achieve cannot be easily predicted.
It should also be underlined that AAA ABSs issued in Europe had average total losses over the period 2000-2013 of 0.2% of the notional, against 3.6% for the U.S. securitisations.  The discrepancy is even higher if the performance of non-AAA investment grade ABS are considered: for the same period, the average losses for such European securitisations amounted to about 3.1%, while it reached 25% in the case of U.S. securitisations. And these average figures are for all types of ABSs, including complex ones that are no longer accepted in our operations. Average total losses would thus have been much lower for high-quality ABSs, from which we will buy only senior tranches.
The role of fiscal and structural policies
With these measures, the ECB reasserts its full responsibility for the maintenance of price stability in the euro area over the medium term. We are confident that our new non-standard measures will help ensure a faster return of inflation towards levels below, but closer to 2%.
It is however important that other policies also play their part.
Within the boundaries set by the Stability and Growth Pact, fiscal policy could contribute to support the recovery. Avoiding an unduly contractionary fiscal stance would be helpful at a time in which the ability for monetary policy to become more expansionary is limited by the zero bound constraint. A more active policy of investment in public infrastructure would be a way of implementing that fiscal stance.
At the same time, structural reforms remain necessary. The average growth rate in many European countries has been disappointingly low over the pre-crisis years. After the crisis, there is a risk that trend growth is reduced further. An extreme, adverse scenario of “secular stagnation”, i.e. a situation where the long run growth potential of the economy falls further on a permanent basis, has reappeared in the public debate.  To avert this scenario, increasing the growth potential of our economies is crucially important. Structural reforms to stimulate productivity growth should reduce rigidities to employment adjustment and ensure that resources in general can be reallocated towards the most highly-skilled and most productive sectors. Product market regulations should also be relaxed to allow entrepreneurs to fully reap the incentives of investing in high-growth sectors.
Let me conclude.
The main challenge monetary policy faces in the euro area today is to avert the risk of a prolonged period of excessively low inflation. The ECB’s new monetary policy measures must be understood in this light. They aim to ensure a steady return to a situation of price stability and, at the same time, support the economic recovery.
While I have not dwelled on this aspect today, we are also acting in parallel on the supervisory side. We are close to finalising the comprehensive assessment of banks’ balance sheets, which is of key importance to overcome credit supply constraints and help address the persistently weak credit growth.
A more expansionary monetary policy, a better position of the banks to support the recovery after our Comprehensive Assessment and the support of fiscal and structural policies will combine to foster aggregate demand, reduce the economic slack, normalize inflation expectations and inflation itself. These combined effects can overcome the present economic environment that is clouding the euro area prospects.
Thank you for your attention.
See Art. 127 of the Treaty on the Functioning of the European Union, and Art. 3 of the Treaty on European Union.
Adjusted for loan sales and securitisation
Adjusted for loan sales and securitisation
John Williams (2013) presents a survey of several studies and reports that USD 600 billion of FED asset purchases achieves a result equivalent to a cut in the federal funds rate of 0.75 to 1 percentage point.
According to the rating agency Fitch.
The notion was first put forward in the thirties by Alvin Hansen, “Economic Progress and Declining Population Growth.” American Economic Review 29, 1939, pp. 1–15. See the recent ebook published by Vox.eu: “Secular Stagnation: Facts, Causes and Cures Edited by Coen Teulings and Richard Baldwin