Monetary Policy Implementation: Lessons from the past and challenges ahead. Opening speech at the ECB Workshop
Speech by Otmar Issing, Member of the Executive Board of the ECB,
Frankfurt am Main 20 January 2005
Ladies and gentlemen,
It is a great pleasure to address such a distinguished audience of academics and practitioners specialised in the field of monetary policy implementation. This workshop is a timely and important event. It will give us the opportunity to take stock of the changes that the major central banks have recently introduced in their monetary policy operational frameworks, and also to learn from developments that are taking place in many of the other central banks represented here.
In a few moments, you will discuss and compare monetary policy implementation in some of the main areas in the world, namely in Japan, the United States, the United Kingdom and within the euro area.
During the rest of the day, you will then enter more specialised fields, starting with central bank auctions and the design of operational frameworks. I am glad to see that your contributions will give a very diverse yet comprehensive picture of the main issues that are of concern to us when we conduct our operations on the open market. In particular, you will look at the bidding behaviour of counterparties at our liquidity tenders and the role of standing facilities.
Tomorrow morning, you will tackle the issue of money market infrastructure and attend a promising panel discussion on “central banks and markets”.
This is a very ambitious programme, which I would wish to “preface” with a short exposition of our experience with monetary policy implementation in the euro area since 1999. While we have faced many challenges over this period, our framework has proved to be adaptable, flexible and robust. I hope that I can convince you that – as I honestly believe – the performance of the Eurosystem’s operational framework has been one of the ECB’s major successes over this crucial period.
The functions and general principles of the operational framework of the Eurosystem
Before being a little more concrete to convince you of the robustness of the Eurosystem’s operational framework, let me try to summarise the main features of the Eurosystem’s approach to monetary policy implementation. As you may know, the Treaty of the European Union did not define a precise set of instruments for the ECB; rather, it was left entirely to the ECB to decide on its operational framework. This is quite unusual, if not unique in the world of central banking.
Indeed, the main elements of this framework were already prepared before the ECB came into existence. This was necessary because it took a significant lead time to prepare the transition from a diverse range of national frameworks to a framework which was truly uniform and harmonised. It would have been too late, when the ECB came into existence 7 months before the start of the single monetary policy, to start the discussions and preparations. The EMI, which was the predecessor of the ECB, tried to set up a framework which was based on the large range of experiences of the then 15 EU central banks. One main element of this framework was that it should be flexible, adaptable to a large set of potentially unforeseeable circumstances.
The EMI set forward the following functions for the operational framework: to steer money market interest rates and contain their volatility, to signal monetary policy intentions, to provide basic refinancing, to absorb liquidity and to influence the structural liquidity position vis-à-vis the central bank.
In addition to these functions, which were subsumed under the heading “operational efficiency”, the framework was expected to be in conformity with market principles – as requested by the Treaty - (and also, to quote the most relevant principles: equal treatment, decentralisation, harmonisation, simplicity and transparency and continuity).
It may also be important to recall that, in the event of conflicts between principles, operational efficiency was deemed to be of overriding importance
The specifics of monetary policy implementation in the euro area
After extensive preparatory work at the EMI and drawing on the experience of central banks prior to Stage III, the ECB chose a set of three main instruments which are both simple and efficient: open market operations, standing facilities and reserve requirements. It chose to rely on self-regulating market mechanisms. It also chose to innovate while ensuring continuity.
The open market operations and standing facilities serve to steer short-term money market interest rates and limit interest rate volatility. The marginal lending facility and deposit facility define the corridor within which the overnight rate can fluctuate. In addition, the ECB requires credit institutions to hold minimum reserves with the ESCB, the level of which are determined in relation to their reserve base. Their most important function is to stabilise money market rates through the averaging provision mechanism; they also increase the demand for central bank money by creating or enlarging a structural liquidity shortage in the market. From my experience at the Bundesbank, it was straightforward that we should have such a system – which was opposed strongly by a minority in the EMI times – but at the same time we must avoid the distortionary impact of the tax character on certain banking activities. Therefore, minimum reserves are remunerated at essentially market rates and thus holding them does not impose a cost on the banking sector.
Using these instruments, the Eurosystem’s approach to monetary policy implementation relies largely on self-regulating market mechanisms. One clear example of this is the ECB’s limited presence in the open market – the so-called “hands-off approach” with very limited direct interventions in the market, typically once a week. The ECB has been able to steer liquidity and interest rates in a smooth manner and so, by stabilising money market rates, ensure the transmission of monetary policy impulses to the whole economy. This success reflects the high degree of credibility surrounding its operational potential and ability to manage liquidity. In addition, these tools have shown that the ECB’s monetary policy is highly adaptable to a changing financial and economic environment.
Finally, the Eurosystem stroke a balance between being innovative and ensuring some continuity in the way monetary policy is implemented. In particular, we retained some degree of flexibility to control short-term interest rates around the target rate. The Eurosystem, like earlier the Bundesbank and many of the national central banks joining EMU, never got tempted to formulate an operational target. This allows us not to be in the market at a very high frequency.
Challenges and robustness of the operational framework
The overall assessment of the framework against the above set of objectives has been very positive since the beginning of Stage III of Monetary Union. In our experience, these monetary policy instruments have proven to be exceptionally flexible and robust.
First, liquidity conditions and short-term interest rates have been steered in a smooth fashion. I do not need to recall, for example, that the volatility of short-term interest rates has remained lower in the euro money market than what had been seen earlier for example in Germany, Italy, or Spain in Stage Two of Economic and Monetary Union. This is also true by international standards.
Consistent with the hands-off approach built into the design of the framework, these results have been achieved with extremely little recourse to fine-tuning operations, i.e. only with the combination “minimum reserve system + averaging + weekly OMOs”. In this context, the set-up of the two standing facilities was effective in containing the fluctuations of overnight rates within limits.
Second, the framework – with both MROs and LTROs – has met the objectives of both providing longer-term liquidity to credit institutions and giving the Eurosystem enough flexibility to steer liquidity developments with adequate precision in the short term.
Third, the “Eurosystem’s style” showed since its inception its high degree of flexibility in adapting to changing financial environments. I will now illustrate a bit more concretely these four characteristics.
I realise that to be fair, my assessment should be a bit more concrete and include an overview of the challenges that the operational framework of the Eurosystem has faced. I will show that overall, the operational framework was suited to address them.
Part of these challenges were of a rather “exogenous” nature.
No special ad-hoc procedures had to be introduced to address the special challenges of the Y2K crisis.
In 2001, the operational framework experienced particular pressures in the aftermath of the September 11 terrorist attacks in the US. In this exceptional situation, you may recall that fine-tuning operations were important instruments that helped containing variability in overnight rates. Through them, we provided liquidity smoothly and promptly.
We then had the cash changeover in January 2002. In this context, the uncertainty concerning banknotes in circulation led to volatility in liquidity conditions together with some tensions in short-term interest rates. As insurance against the uncertainty, the ECB followed a policy of ample liquidity in all MROs in January 2002 and used communication with the market very intensively. In fact, the impact on interest rate volatility from the cash changeover was well contained.
Other challenges were more inherent to the way the framework was specified.
One issue identified at the early stages concerned the distribution and diversity of collateral for individual counterparties. In fact, the Eurosystem paid a lot of attention, in particular in 1999 and part of 2000, to the diversity of the assets pledgeable as collateral, which appeared to be complex to resolve given the variety in financial structures and traditions across the euro area. However, the definition of two tiers of eligible collateral has proved effective in eliminating those concerns. The forthcoming establishment of a single collateral list should facilitate pledging even further.
Another difficulty arose with the fixed rate tender procedure chosen at the inception of the operational framework. As you know, fixed rate tenders suffered from overbidding in a context of upward interest rate expectations. But in fact, overbidding was soon eliminated by adopting in June 2000 the variable rate tender procedure with a minimum bid rate. Subsequently, episodes of underbidding, and perhaps some market volatility, occurred in the main refinancing operations of the ECB in the context of strong expectations of interest rate cuts within the maintenance period. However in general, the volatility was not transmitted to longer maturities, which are more important for economic activity. In any case – and you will hear about it during the workshop - the modifications introduced to the framework in March 2004 imply that these concerns have become obsolete.
All in all, the impact of these challenges was modest and should not detract from overall success. Moreover, the system was able to quickly and flexibly address these issues.
Let me conclude.
Operational frameworks have to adapt to the economic environment within which monetary policy is conducted. They also have to react, sometimes in real time, to the behaviour of all parties with which central banks interact when implementing their monetary policy decisions.
The brief history of monetary policy implementation within the Eurosystem is a success story. This success is collective. The implementation of monetary policy within the euro area is the outcome of centralised decision-taking and decentralised operational actions. You might say that “centralised” and “decentralisation” are a somewhat odd couple of words, sometimes almost an oxymoron. Experience shows that this has not been the case for the implementation of monetary policy within the Eurosystem. The choice of a “system” to carry out central functions for the euro, building on established central bank structures, has made a fruitful use of the existing institutional set-ups, infrastructures, capabilities and expertise in this field. It has been an emulating choice that ensured the efficiency of operational management within the Eurosystem, and perhaps the best example of the “team-work” within the Eurosystem on which we need to rely and build as we confront the challenges of the future.
Experience shows that operational frameworks have grown out of historical processes; they are not static but they evolve over time. In the case of the euro area, the design of the operational framework offered a unique opportunity, to experts and decision-makers in charge at the time, to start with a “blank sheet” and reflect upon the experiences that could be valuable and upon which they could build.
Thus far, this framework has proven to be extraordinarily resilient. We had hardly any changes to it in the first few years. And I am optimistic that the framework will also be robust against many of the forthcoming challenges we will face in the future.
Thank your very much for your attention. I wish you a fruitful and stimulating workshop.