The current euro area environment, with policy rates required to stay low for a prolonged period of time and an apparent disconnect between the business and financial cycle, clearly points to a situation where monetary policy cannot deviate from price stability objectives to influence the financial cycle. This is the task of macroprudential policy. While acknowledged in principle, this fact has not yet been fully reflected in our policy frameworks.
Two major moves are required. First, macroprudential policy must place greater emphasis on preventing large fluctuations in the financial cycle, rather than simply increasing resilience to shocks when they occur. In addition to the bank-side capital based measures enhancing banks’ resilience, borrower-based instruments (such as LTVs or DSTIs), which have proved to be more effective in curtailing excessive credit growth, and are also applicable in a time-varying fashion, should gain more prominence. In particular, borrower-based measures should be properly embedded in European legislation, which is not the case at present. Second, a broader macroprudential toolkit is needed to address risks stemming from the shadow banking sector due to its increasing role in credit intermediation. This could involve measures such as redemption gates and loading fees to provide additional safeguards. Guided stress tests can provide comparable assessments of the health of individual institutions and of the resilience of the financial system as a whole. Appropriate policy responses to mitigate growing risks need however to be calibrated, in order to ensure a contained impact on credit supply to the real economy.
The financial crisis has shown that price stability is not sufficient to guarantee financial stability. The financial cycle and the business cycle are not synchronised, implying that risks can emerge especially in the periods of “disconnect” between the two cycles. In the run-up to the financial crisis, imbalances were building-up while inflation was low and stable. At present, the search for yield phenomenon continues against the very low inflation, subdued growth and low interest rate environment.
Monetary policy aims at ensuring price stability in the market for goods and services. It should not be used to address pockets of instability in asset markets. This falls under the remit of macro-prudential policy, aimed at safeguarding stability of the financial system and containing systemic risk. At present, in advance economies, monetary policy needs to stabilise prices and to continue supporting real activity, while macro-prudential policy needs to tame the financial sector in asset market segments showing signs of exuberance or where imbalances could be forming.
Financial stability objectives can only be achieved with an effective macro-prudential policy. This requires policy interventions in a timely and bold manner, significantly affecting the normal behaviour of financial markets or financial institutions. This poses great challenges. First, measures would need to be admittedly intrusive, going well beyond the new capital and liquidity regulatory framework. Secondly, the macro-prudential tool-kit that has been legislated – including the one entrusted to the ECB/SSM – is not complete, it is centred on banks. Instruments would need to address other financial activities and institutions, notably pertaining to the steadily growing “shadow banking” sector. Advanced economies will only be able to ensure financial stability with effective macro-prudential policy interventions.
The monetary policy experience of the past seven years is reviewed. In pursuit of its objectives, the ECB has been very flexible in adjusting and expanding its toolkit.
In a first phase, from 2008 to 2013, monetary policy measures aimed at easing financial constraints arising from malfunctioning money and funding markets. Non-standard monetary policy was conducted in a context of well-anchored inflation expectations. It was not aimed at, but unavoidably resulted in, the expansion of the ECB's balance sheet.
The second phase, since 2013, is characterised by a more active use of the ECB’s balance sheet, as inflation started to fall significantly below 2%, accompanied by declines in various measures of long-term inflation expectations. Non-standard measures, introduced as from July 2013, included a policy of forward guidance, asset purchase programmes of private debt, a programme to provide targeted long-term funding to banks and an enlargement of the asset purchase programme to include sovereign bonds.
A number of concerns have been voiced regarding the adoption of a large scale asset purchase programme (APP) in the euro area. It is argued that these concerns are unfounded since: the transmission channels of the APP go well beyond the direct effect on the price and yield of the purchased assets; government fiscal discipline should not be achieved at the expense of central bank independence; central banks have instruments to absorb the effects of an expanded monetary base should inflation become a risk in the future; and finally, exuberance in specific asset markets should be addressed with macro-prudential policy tools, at national level, since price stability relevant for monetary policy refers to the market of goods and services, not to asset markets at large.
At the moment, the euro area is suffering mostly from weak aggregate demand. Supply-side policies are necessary to increase the medium-term growth potential. Monetary policy, aiming at price stability by stimulating demand and supporting investment, should reduce employment and output gaps, thereby positively affecting medium-term growth.