Reflections on the nature of monetary policy non-standard measures and finance theory

Speech by Jean-Claude Trichet, President of the ECB,
Opening address at the ECB Central Banking Conference
Frankfurt, 18 November 2010

1. Introduction

It is a great pleasure to open the ECB’s 2010 Central Banking Conference.

As you know, we consider this event, which has been held every other year since 2000, as our institution’s flagship conference.

I am therefore particularly pleased to see that so many central bank governors from around the world have taken up our invitation, as well as representatives from European institutions and governments, leading academics, financial market participants and many other friends of the ECB. This year, we also have about 30 graduate students from all over Europe with us. A very warm welcome to all of you, on behalf of the Executive Board and Governing Council of the European Central Bank.

As ever, the goal of the conference is to bring together central bankers, policy-makers, academics, market participants and other observers to exchange views on topics of crucial relevance to central banks. I am sure that you will all agree that the theme of the conference – “Approaches to monetary policy revisited: lessons from the crisis” – is both relevant and timely.

I think we have an inspiring work ahead of us for these two days: it is packed with a combination of papers and panels, and I am very much looking forward to our discussions.

In these opening remarks, I would like to do two things. First, I will present a “bird’s eye” view of the ECB’s conduct of monetary policy during the crisis, focusing in particular on the distinction between standard and non-standard policy measures. And second, I will identify some main lessons to be learned from the crisis regarding economic analysis.

2. The role of standard and non-standard measures

Let me start with monetary policy. The widespread introduction of non-standard monetary policy measures has been a defining characteristic of the global financial crisis.

Across central banks, there has been no standardisation of non-standard measures: approaches are distinct, tailored to the respective economies and their structures. We have seen enhanced credit support, credit easing, quantitative easing, interventions in foreign exchange and securities markets, and the provision of liquidity in foreign currency – to name but a few of the measures taken. [1]

These tools have been used to support the functioning of the financial sector, to protect the real economy from the fallout of the financial crisis, and, ultimately, to preserve price stability over the medium term.

There are two distinct views on non-standard measures.

Some view them as the continuation of standard policy by other means. Once nominal interest rates cannot be lowered further, central banks use other tools to determine the monetary policy stance – that is, to contribute in the desired way to economic, financial and monetary developments in pursuit of price stability. [2]

Figuratively speaking, this can be compared to – once the end of the road has been reached – engaging the four-wheel drive. Central banks expand their balance sheets and inject liquidity so as to influence the structure of yields and returns and thereby stimulate aggregate demand. This approach would be broadly in line with the theoretical analyses and prescriptions of Friedman, Tobin or Patinkin. The logic of this approach is essentially sequential: first the standard measures, then the non-standard measures. If this sequential logic were also to be applied to the exit, it would essentially mean unwinding non-standard measures first and subsequently raising interest rates.

At the ECB, we have a different view of our non-standard measures. We set our key interest rates at levels we consider appropriate to maintain price stability, drawing on our regular comprehensive assessment of economic and monetary conditions. In other words, we have followed our standard practice in this regard.

But on several occasions, the monetary policy stance established in this way faced obstacles in being transmitted to the euro area economy. During the financial crisis, market functioning was impaired. In response, we acted to overcome some severe malfunctioning that was hampering the channels of transmission of our policy. We introduced measures to help restoring a more effective transmission of our monetary policy stance to the wider euro area economy. [3]

Staying with the image of the road, I would say that we sought to remove the major roadblocks in front of us, so that our policy stance could be transmitted to the economy in the intended way. The logic of this approach is therefore parallel and supportive: if the transmission of the standard measures is impeded in a very significant way, non-standard measures can offer support. This logic has potentially very clear implications for the exit: we consider that we can determine standard and non-standard measures largely independently. We consider that we are not bound to unwind non-standard measures before considering interest rate increases; we could do one or the other or both. One set of measures depends on the outlook for price stability, the other depends on the degree of functioning of the monetary policy transmission through the financial system and financial markets.

With this overview of guiding principles in mind, I would like to discuss the three crucial elements of our monetary policy discussions during the financial crisis in more detail: the unwavering pursuit of price stability, our primary objective; the role of standard policy measures in pursuing that goal; and the support provided by the non-standard measures that we have introduced in recent years.

Price stability

The Governing Council has defined the ECB’s primary objective with a definition of inflation of “below 2%, but close to 2%” over the medium term. [4]

As some of you will remember, such quantification of our definition was initially much criticised, but over time has become fully accepted. Some doubts of the critics have proved unfounded. Our definition has not constrained growth: during the first ten years of Monetary Union, euro area per capita GDP growth was comparable to that seen in the United States, at about 1% per annum. Nor has it hindered employment creation: between 1999 and the second quarter of 2010 euro area employment grew by 14.2 million, which compares favourably with employment creation in the US over the same period. [5]

What is more, can I say that I was also impressed by a recent speech of my colleague and friend, Chairman Ben Bernanke. [6] When describing the longer-run US inflation rate and outlook, he mentioned as consistent with the Federal Reserve’s mandate a longer-run inflation rate of “about 2 percent or a bit below”. The world’s two largest central banks in the advanced economies could hardly be more closely aligned with regard to the inflation rates they aim to establish in their respective economies over the medium term.

At the same time, it seems to me that our medium-term orientation has become more fully understood. We need to look beyond the impact of transient shocks to price developments and thus beyond the standard two to three-year horizon of conventional macroeconomic projections. Indeed, we condition our policy-relevant horizon on the nature and magnitude of the shocks hitting the economy. The nature and magnitude of the shocks faced during the financial crisis imply that the relevant notion of medium term might be somewhat longer than in more normal circumstances.

With these definitional issues largely resolved, there are two points that I would particularly like to highlight today.

First, the precise quantitative nature of our definition of the price stability objective has proved crucial in anchoring longer-term inflation expectations. And, as a result, it has protected us against both upside and downside risks to price stability, even in these most turbulent of times. The anchoring of private inflation expectations induces a self-correcting mechanism in response to temporary disturbances in price developments, thereby easing the burden on monetary policy. In short, the quantitative definition has helped protect us against the materialisation of the risks of deflation, even at the darkest moments of the crisis.

Second, the quantitative definition facilitates accountability. There should be no room for ambiguity in judging the ECB’s track record. The average annual inflation rate in the euro area since January 1999 has been 1.97%. This represents an achievement that is worth taking note of. It is, moreover, the best result in the major euro area countries in over 50 years.

Standard measures

How could these results be achieved in the face of financial crisis? Changes in the ECB’s key short-term interest rates – in other words, standard policy measures – have remained the key instrument of monetary policy in the euro area. These rates have always been set at levels which the Governing Council has deemed appropriate for the delivery of price stability over the medium term.

In considering the implementation of standard monetary policy measures during the financial crisis, two issues are worth particular attention.

First, the close relationship normally observed between the key policy rate and short-term money market rates assumed a more complex form during the crisis. [7] It was important to recognise that in times of crisis a broader set of market interest rates, extending beyond the very short-term money market rates, was relevant in signalling the monetary policy stance, given the segmentation of financial markets, also taking into account that only a fraction of the banks had access to the unsecured Eonia rate. [8] Hence, the new positioning of the overnight money market rate was considered acceptable in these exceptional circumstances as a means of helping to offset the impaired functioning of the money market and, in particular, the abnormally high level of spreads on the term money market rates.

The second point I would like to highlight concerns the question of “forward guidance” or “pre-commitment” regarding the future path of key ECB interest rates. Let me emphasise that the Governing Council has never pre-committed to future interest rate decisions. It did not do so during the financial crisis. The main reason in our view is the need for the central bank to retain the ability to react to unforeseeable contingencies without destabilising market expectations.

Non-standard measures

But, in the challenging context of financial crisis, standard monetary policy proved insufficient. Standard measures have been complemented by a variety of non-standard measures, which have aimed to support the effectiveness and transmission of interest rate decisions.

As I mentioned at the outset, the ECB did not embark on non-standard measures because we thought the scope for further standard easing of the monetary policy stance had been exhausted. On the contrary, when the key rate was reduced to 1% in May 2009, I remarked: “we did not decide today that the new level of our policy rates was the lowest level that can never be crossed, whatever future circumstances may be”. [9] We judged then – as we do now – that the level of our key rates was appropriate to serve the maintenance of price stability over the medium term.

Rather, our view was that non-standard measures were required to ensure that the stance of monetary policy was effectively transmitted to the broader economy, notwithstanding the dysfunctional situation in some financial markets.

Two episodes are of particular note.

First, the functioning of the euro interbank money market was impaired, to a greater or lesser extent, from the bankruptcy of Lehman Brothers in September 2008 through the whole of 2009. Given the crucial role of wholesale money markets for monetary policy transmission, dangers were immediately apparent. The flow of credit to the productive sectors of the economy – households and firms – was at risk, as banks faced massive uncertainty about their access to liquidity and funding, both in euro and foreign currencies.

Concerns about the impact of such tensions on bank credit supply were particularly acute in the euro area, given the preponderance of bank loans in corporate financing. About 70% of firms’ external financing in the euro area comes via the banking system, compared with only 30% in the United States.

To contain these risks, prompt and decisive action needed to be taken: full allotment, the lengthening of maturities in liquidity provision, the expansion of collateral, the provision of liquidity in foreign currencies and a covered bond purchase programme to support this systemically important market in Europe. All these measures were aimed at supporting bank funding and maintaining the regular flow of bank credit to the private sector.

The second episode relates to the emergence of tensions in European sovereign debt markets earlier this year. Again, given the central role played by government bond markets in the financial system, dysfunctionality in these market segments threatened the effective transmission of monetary policy.

We must remain mindful that the euro area consists of 16 sovereign states. It is not a fully-fledged political union or a fiscal federation, within a unified government bond market. The SMP programme has been designed to help restoring a more normal functioning of the monetary policy transmission channels in countries where the sovereign debt markets were starting to be dysfunctional.

In light of these different episodes, what more general conclusions can be drawn regarding the ECB’s non-standard measures? I would identify five principles that have shaped our thinking about these measures.

First, the design and implementation of such measures remains focused on the ECB’s primary objective – the maintenance of price stability.

Second, non-standard measures are not intended to “fine-tune” the transmission mechanism. Instead, they aim to remove the major roadblocks. If you like, there is a “threshold effect”: the measures must address a problem of significant magnitude to warrant exceptional action.

Third, the instruments employed in implementing such non-standard measures must lie within the usual realm of central banking. While rather exceptional (at least in the ECB’s experience prior to the outbreak of the crisis), measures such as full allotment tenders at fixed rates, operations with one-year maturity and outright purchases or market operations in government bonds are all part of the traditional central bank armoury.

Fourth, the non-standard measures, by their nature, are temporary to the extent that they have to be strictly commensurate to the degree of dysfunctionality of markets that is hampering the transmission mechanism. The central bank must guard against the danger that the necessary measures in a crisis period would evolve into a dependency as conditions normalise.

This naturally leads to the fifth principle: non-standard measures must be fully accompanied by an environment aiming at reactivating the private markets. In particular, the private sector, regulators and supervisors, and the fiscal authorities must face the right incentives to address the major underlying problems, such as distressed banks or fiscal weaknesses.

As we look to the future, these basic principles will continue to govern our approach to the conduct of monetary policy in the euro area, through both standard and non-standard means.

3. Lessons from the crisis for macroeconomics and finance theory

Allow me now to turn to the broader issue of lessons from the crisis for macroeconomics and finance.

When the crisis came, the serious limitations of existing economic and financial models immediately became apparent. Arbitrage broke down in many market segments, as markets froze and market participants were gripped by panic. Macro models failed to predict the crisis and seemed incapable of explaining what was happening to the economy in a convincing manner. [10] As a policy-maker during the crisis, I found the available models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.

In the absence of clear guidance from existing analytical frameworks, policy-makers had to place particular reliance on our experience. Judgement and experience inevitably played a key role.

In exercising judgement, we were helped by one area of the economic literature: historical analysis. Historical studies of specific crisis episodes highlighted potential problems which could be expected. [11] And they pointed to possible solutions. [12] Most importantly, the historical record told us what mistakes to avoid. [13] On this point, I look forward to this afternoon’s discussion in our economic history panel.

But relying on judgement inevitably involves risks. We need macroeconomic and financial models to discipline and structure our judgemental analysis. How should such models evolve?

The key lesson I would draw from our experience is the danger of relying on a single tool, methodology or paradigm. Policy-makers need to have input from various theoretical perspectives and from a range of empirical approaches. Open debate and a diversity of views must be cultivated – admittedly not always an easy task in an institution such as a central bank. We do not need to throw out our DSGE and asset-pricing models: rather we need to develop complementary tools to improve the robustness of our overall framework.

Which lines of extension are most promising? Let me mention three avenues that I think may have been neglected by the existing literature.

First, we have to think about how to characterise the homo economicus at the heart of any model. The atomistic, optimising agents underlying existing models do not capture behaviour during a crisis period. We need to deal better with heterogeneity across agents and the interaction among those heterogeneous agents. We need to entertain alternative motivations for economic choices. Behavioural economics draws on psychology to explain decisions made in crisis circumstances. [14] Agent-based modelling dispenses with the optimisation assumption and allows for more complex interactions between agents. [15] Such approaches are worthy of our attention.

Second, we may need to consider a richer characterisation of expectation formation. Rational expectations theory has brought macroeconomic analysis a long way over the past four decades. But there is a clear need to re-examine this assumption. Very encouraging work is under way on new concepts, such as learning [16] and rational inattention. [17]

Third, we need to better integrate the crucial role played by the financial system into our macroeconomic models. One approach appends a financial sector to the existing framework, [18] but more far-reaching amendments may be required. In particular, dealing with the non-linear behaviour of the financial system will be important, so as to account for the pro-cyclical build up of leverage and vulnerabilities. [19]

These are certainly areas of rich potential, as I think we will hear tomorrow in our panel session on alternative approaches to economic analysis.

In this context, I would very much welcome inspiration from other disciplines: physics, engineering, psychology, biology. Bringing experts from these fields together with economists and central bankers is potentially very creative and valuable. [20] Scientists have developed sophisticated tools for analysing complex dynamic systems in a rigorous way. [21] These models have proved helpful in understanding many important but complex phenomena: epidemics, weather patterns, crowd psychology, magnetic fields. Such tools have been applied by market practitioners to portfolio management decisions, on occasion with some success. I am hopeful that central banks can also benefit from these insights in developing tools to analyse financial markets and monetary policy transmission.

An important perspective that researchers in other fields bring to economics is a focus on identifying the features that explain economic systems as we know them. A large number of aspects of the observed behaviour of financial markets is hard reconcile with the efficient markets hypothesis, [22] at the heart of most conventional models. [23] Of course, establishing what are the key features remains an unresolved and difficult problem. [24] But a determinedly empirical approach – which places a premium on inductive reasoning based on the data, rather than deductive reasoning grounded in abstract premises or assumptions – lies at the heart of these methods. In operationalising these insights, simulations will play a helpful role. [25] Using such approaches can help deepen our understanding of market dynamics and the behaviour of the economy.

4. Conclusions

The lessons of the financial crisis for macroeconomic and financial analysis are profound. And the current situation remains very demanding.

Our economies and citizens deeply rely on decisions by policy-makers. These, in turn, rely very much on two foundations in the economic field: the credibility of central banks and the credibility of governments. The credibility of central banks relies on their capacity to deliver price stability over the medium term in line with their definition of price stability, and thereby solidly anchoring inflation expectations. The credibility of governments means that they must preserve and consolidate their creditworthiness. In order to do so, they need in particular to consolidate public finances and thereby contribute to longer-run and sustainable growth.

In one sentence: in this still exceptionally demanding and uncertain environment for the financial sector and the real economy, it is essential to preserve and reinforce the authority of public authorities.

A word on the European Union and euro area governance. As you know, the ECB Governing Council has constantly called upon executive branches, since its inception, to apply strictly, preserve and reinforce the fiscal and economic governance of the euro area. In 2004 we defended fiercely the Stability and Growth Pact which was under attack by the major countries of Europe. In 2005 we expressed solemnly our “grave concerns” as regards the amendments brought about to the corrective arm of the Pact. Also in 2005 we called for enlarging governance of the euro area to the surveillance of competitive indicators and imbalances. In the past days, taking into account the lessons of the global crisis, in particular as regards its impact on the European single market and in the single currency area, we have called, and are still calling, for a quantum leap of governance. Every day I am even more convinced that this is absolutely essential. And I am sending this message, as solemnly today, as in 2005 when I expressed, on behalf of the Governing Council those “grave concerns” that I just quoted.

Thank you for your attention.



[1]For a summary, see: C. Borio and P. Disyata (2009), “Unconventional monetary polices: An appraisal”, BIS working paper No 292.

[2]For a discussion of this perspective, see: A. Orphanides and V. Wieland (2000), “Efficient monetary policy design near price stability”, Journal of the Japanese and International Economies 14, pp. 327-365.

[3]For a discussion, see: D. Giannone, M. Lenza, H. Pill and L. Reichlin (2010), “Non-standard monetary policy measures and monetary developments” in J. Chadha and S. Holly (eds.) Lessons for monetary policy from the financial crisis, forthcoming (Cambridge University Press).

[4]See ECB (2003), “The outcome of the ECB’s evaluation of its monetary policy strategy”, Monthly Bulletin (June), pp. 79-92.

[5] Source: Eurostat, ECB; BEA, BLS and current population survey (for US 2010Q2 figures).

[6]See: B.S. Bernanke (2010), “Monetary policy objectives and tools in a low inflation environment”, speech at the conference Revisiting monetary policy in a low inflation environment, FRB Boston (available at http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm).

[7]See: ECB (2010), “The ECB’s monetary policy stance during the financial crisis”, Monthly Bulletin (January), pp. 63-72.

[8] See: M. Lenza, H. Pill and L. Reichlin (2010), “Monetary policy in exceptional times”, Economic Policy 62, pp. 295-339.

[9]J-C. Trichet (2009), “Questions and answers” at the ECB press conference 7 May (available at http://www.ecb.europa.eu/press/pressconf/2009/html/is090507.en.html).

[10]See, for example: R.J. Caballero (2010), “Macroeconomics after the crisis: Time to deal with the pretense-of-knowledge syndrome”, NBER working paper No 16429.

[11]See, for example: C.M. Reinhart and K.S. Rogoff (2010), “From financial crash to debt crisis”, NBER working paper No 15795.

[12]See, for example: L. Jonung (2009), “The Swedish model for resolving the banking crisis of 1991-93: Seven reasons why it was successful”, European Commission economic papers No 360.

[13]For an example of the guidance offered by economic history, see: B.S. Bernanke (2000), Essays on the Great Depression, Princeton University Press.

[14] See, for example: P. Diamond and H. Vartiainen (eds.) (2007), Behavioral economics and its applications, Princeton University Press.

[15] See, for example: B. Le Baron (2000), “Agent-based computational finance: Suggested readings and early research”, Journal of Economic Dynamics and Control 24, pp. 679-702.

[16]See: G.W. Evans and S. Honkapohja (2001), Learning and expectations in macroeconomics, Princeton University Press.

[17]See, for instance: C.A. Sims (2003), “Implications of rational inattention,” Journal of Monetary Economics 50(3), pp. 665-690; B. Mackowiak and M. Wiederholt (2009), “Optimal sticky prices under rational inattention”, American Economic Review 99(3), pp. 769-803.

[18]See: L.J. Christiano, R. Motto and M. Rostagno (2003). “The Great Depression and the Friedman-Schwartz hypothesis”, Journal of Money, Credit and Banking 35(6), pp. 1119-98.

[19]See: J. Geanakoplos (2010). “The leverage cycle,” NBER Macroeconomics Annual 24, pp. 1-65

[20]One example of such interaction was the conference “New directions for understanding systemic risk” organised by the Federal Reserve Bank of New York and the US National Academy of Sciences in May 2006 (see the proceedings reported at http://www.newyorkfed.org/research/epr/2007n1.html).

[21]Such techniques rely on models: built on the law of large numbers, exemplified by the statistical physics underlying modern thermodynamics; or that rely on advances in mathematical analysis, as embodied in hydrodynamics and turbulence theory. The main unifying theme is that a complex ‘macro’ phenomenon is explained by postulating some simple behaviour of a ‘micro’ element (an atom, particle or molecule) at the basis of the process under study and evaluating these postulates empirically using statistical and simulation methods.

[22]“Efficient capital markets: A review of theory and empirical work,” Journal of Finance 25(2), pp. 383–417.

[23]See: J. Farmer and J. Geanakoplos (2008), “The virtues and vices of equilibrium and the future of financial economics”, Cowles Foundation Discussion paper No. 1647

[24]See: J-P. Bouchaud (2010), “The endogenous dynamics of markets: Price impact and feedback loops,” arXiv: 1009.2928v1 (15 September 2010)..

[25]See: J-P. Bouchaud (2009), “The (unfortunate) complexity of the economy,” Physics World (April), pp. 28-32.

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