Tradition and innovation in monetary policy
More than six years after the start of the global financial crisis, monetary policy in the euro area still faces major challenges.
Monetary policy, the ECB, faces a challenge – perhaps more than ever before.
It faces a challenge because inflation rates are too low. At 0.4% for the whole euro area, the inflation rate is well below our target of nearly 2%. The prospects for economic growth and further price developments in the medium term are subdued. Monetary growth and lending are weak. Geopolitical risks are adding to the uncertainties which are causing investor appetite to continue to fall.
Expectations of the ECB are high, from markets and from politicians. Every month people give us good advice, often referring to actions taken by other central banks. And they do so despite the fact that our monetary policy decisions from June and September haven’t yet been able to fully take effect.
So what else can a central bank do in the current situation? How innovative may central banks be? How innovative is an ECB allowed to be, which as a start-up from the year 1999 is in many ways itself an innovation, and as a custodian of a currency without a state can only partly be compared with other central banks.
I think we can all readily agree that innovation cannot be an end in itself. The ECB must and will act only in accordance with its mandate. Price stability is the guiding principle of our actions. There can be no innovations in the definition of our mandate. Moreover, in uncertain times of crisis a clear focus is not less, but doubly important. Central banks therefore have a particularly strong understanding of tradition, and for a good reason: monetary policy is all about trust, reliability and consistency.
Innovative measures must therefore be judged against our mandate of maintaining and creating price stability. As with any decision, innovation demands a sober analysis of the costs and benefits, the opportunities and risks. Allow me to slip briefly into legalese: innovative monetary policy measures, too, should be appropriate for their objective. Since monetary policy measures also have side effects, a central bank should use the mildest measure that will have the least side effects – that measure must hence be necessary.
Low inflation rates and the catalogue of measures
So what does this mean for the current situation? Consistent monetary policy can and must maintain price stability. No more and no less. We are judged on whether we achieve an average rate of inflation for the euro area as a whole which is in line with our target of below, but close to 2%. The commitment to price stability is symmetrical. That means that the ECB must act in exactly the same way when the target is undershot for a sustained period as when it is overshot. We take a medium-term view when it comes to achieving our target, because our aim is to ensure price stability over the medium term.
At the moment, with the aforementioned inflation rate of 0.4% for the whole euro area, we are a long way off our target.
And in the coming years, too, we can only expect a moderate rise in the inflation rate. There are a number of reasons why the challenges of monetary policy will probably continue to occupy us for quite some time to come. Some banks will still have to adjust their balance sheets, and this applies to an even greater extent to public finances, private companies and households in some countries. This has a structurally dampening effect on overall economic demand, and particularly on investments. Furthermore, important long-term determinants of the real interest rate are pointing downwards: demographic trends, namely longer life expectancy and weak population growth worldwide – but particularly pronounced in the euro area – are creating an environment which necessitates low real interest rates and thus low balanced nominal interest rates.
The euro area suffers from a lack of competitiveness and productivity, which of course take different forms in individual Member States. Structural problems and current weak demand lead to unsatisfactory economic growth and unacceptably high unemployment in many countries. Tackling these challenges is not the job of monetary policy. Crisis management must tackle the root causes for the long term and we, the ECB, will therefore not tire of reminding governments that we can only provide them time for the urgently needed reforms.
Against this backdrop we could ask whether it was appropriate that the ECB took action. I think it was, precisely because of the path of inflation – even if there is room for discussion about some of the measures and their design. The list of our crisis management measures is long. In June and September this year we lowered key interest rates further. The main refinancing rate is now just 5 basis points. The interest rate channel has thus been exhausted. For the first time in our history we have resorted to a negative deposit rate in an effort to achieve the desired monetary policy accommodation within the tried and tested corridor system. This justified monetary policy step – which not least favours investment – was not an easy decision for us, for one because of its possible side effects for the financial sector and for savers. At the same time, we have the tool of forward guidance, which we have used and later reaffirmed: especially in view of the inflation outlook, we expect, on the basis of current data, that the central bank interest rates in the euro area will remain at the current level for an extended period of time.
In addition we have taken a number of targeted unconventional measures which should improve the monetary policy transmission mechanism. One of these is targeted longer-term refinancing operations (TLTROs), with which banks can obtain liquidity for a fixed interest rate for up to four years. We have drafted two purchase programmes, one for covered bonds and one for asset-backed securities (ABS). The purchase programme for covered bonds started in October. So far purchases of around €16 billion have taken place. We started the ABS programme just last week. I anticipate that together the longer-term refinancing operations and both purchase programmes will have a strong impact on the balance sheet of the Eurosystem.
Innovation or imitation
Every month there are fresh calls for further measures. But is it appropriate to contemplate further measures at this moment in time?
Under normal conditions, central banks are in a position to ensure price stability in an environment of positive nominal interest rates by means of conventional interest rate policy. Once interest rates are at zero, central banks are left with only unconventional measures in order to fulfil their mandate. Central banks all over the world have indeed been anything but inactive. In particular, they have significantly expanded their balance sheets, and by making changes in their balance sheet structure they have taken varied measures to make targeted interventions in submarkets affected by liquidity shortfalls, maintain important credit relationships and ensure a functioning monetary policy transmission.
We, too, have turned to innovative measures, to the targeted longer-term refinancing operations and the purchase of covered bonds and asset-backed securities which I mentioned earlier.
For sure, in times such as these we need to be prepared. That is why the ECB’s Governing Council agreed at the beginning of November that, looking ahead, it would closely monitor the appropriateness of its monetary policy stance. In concrete terms, this means that if it should become necessary to further counteract the risks of a prolonged period of low inflation, the Governing Council intends to take additional unconventional measures within its mandate.
Even if it is good to be prepared, one should beware of showing activism.
There is no automatic mechanism to initiate further programmes. The ECB’s Governing Council has not decided on a target for the size of the balance sheet; it has rather unanimously expressed an expectation. A kind of mechanical expansion of the ECB’s balance sheet cannot be an end in itself. All of our decisions are to be evaluated against the background of current and medium-term inflation expectations.
Consequently, we must continually analyse current price increases to identify the components which comprise the weaknesses in price developments. Short-term developments are not key, especially when they are largely determined by energy and food prices. The underlying trend and the firm anchoring of inflation expectations are decisive, as well as the focus on the euro area as a whole. Low inflation rates in some Member States – even when negative – are not in themselves a breach of the target. They can be necessary to restore lost competitiveness. One could also argue about whether it is really necessary to consider further measures given that the measures already taken have not yet been able to have an effect. Monetary policy does not take effect immediately, but only with a certain time lag. As a rule we should take this time and wait and see.
The large-scale purchase of securities, including government bonds, is often seen as a panacea. As I said, for innovative measures too, the costs and benefits, and the opportunities and risks must be carefully considered.
Some central banks have used quantitative easing to quickly and decisively provide monetary policy impetus, adjusted to the specificities of their environment. We are particularly compared to these central banks and their measures. For me, these are idle comparisons. The following saying applies here: those who constantly compare themselves with others might become more like them, but they won’t necessarily become any better.
When making a comparison with the measures of other central banks, people often forget that innovative aspects of monetary policy need to be adapted to the institutional conditions, economic specifics and financing structure which characterise a currency area. Measures which are appropriate in one currency area can be ineffective elsewhere. What seems like the first option in one place may well be the very last resort elsewhere, without there being much difference in the actual aim of the measures.
Instead, we should ask: would such purchases have the desired effect on the rate of inflation? What “quantities” would need to be purchased to have an effect? How long would such effects last?
The euro area is characterised by a bank-based financial system which makes it quite different from more strongly market-based financial systems, particularly in the United Kingdom and the United States. This explains our focus on refinancing operations, which have enabled the banking system to overcome liquidity bottlenecks, maintain credit relationships and enter new credit arrangements. Our measures from June and September 2014 also serve to support the credit channel. In essence, it is about improving funding conditions for borrowers in the real economy. The selective purchase programmes for covered bonds and asset-backed securities follow the same logic.
For a broad securities purchasing programme, shouldn’t we also consider the fact that government securities in the euro area are not without credit risk? In this respect, the interest on national government securities in the euro area doesn’t operate as a benchmark for all further interest rates on refinancing operations, as is the case in the United Kingdom or the United States for example. Besides, the effect of intervening in capital markets in a bank-based financial system is weaker than in a market-based system, as illustrated by wealth effects, for example. Another consideration is that other central banks bought government securities in a different economic environment with considerably higher long-term interest rates. In the euro area, the long-term interest rates on Spanish and Italian government bonds, for example, are already lower than those of the United States or the United Kingdom.
The Eurosystem is currently faced with 18, soon to be 19, issuers of government securities. These securities bear different rates of interest. There are very few shared competencies in fiscal policy. As long as this is the case, the ECB’s purchase of government securities is inevitably linked to a serious incentive problem. Therefore with regard to the purchase of government securities, measures which are obvious in one place could be the last resort at best for us.
As you see, there are more questions than answers at the moment. In my view, a consideration of the costs and benefits, and the opportunities and risks of a broad purchase programme of government bonds does not give a positive outcome at the current time. Today, less than a week before our ECB Governing Council meeting, I can of course only give you some general reflections from my personal point of view.
Owing to my position, I have limited myself today to talking about innovations in monetary policy. Innovations in other political areas are also necessary, if not even more so. Innovative political approaches are called for when it comes to increasing growth potential in the euro area, strengthening economic adjustment efforts and reconciling fiscal consolidation with growth and employment.
But let me conclude by returning to the original question: how innovative may the ECB’s monetary policy be? As innovative as necessary and as effective as possible. This requires careful consideration. The risks and side effects must always be taken into account. As a lawyer I adhere to the principle of proportionality. For me, given the current situation, the hurdles for further measures are very high, especially for broad purchase programmes. The interest rates and spreads on many debt instruments are already very low: the risk of market distortions cannot be dismissed. The deciding factor for all programmes is their effectiveness for the real economy and ultimately for price stability, which is what we – the ECB as the central bank for the whole euro area – must be judged on. Innovation cannot be an end in itself.
At this point I would like to remind you that, since 2012, the financing costs for public borrowers have fallen significantly, as have those for large enterprises with direct access to the capital markets. The reasons for weak growth and funding shortfalls primarily lie elsewhere, not in a lack of central bank liquidity, to say nothing of capital markets. At this point we should first look at the effect of our recent measures and of the asset quality review and the stress test on bank lending. The restoration to health of the banking system and the improvement of all credit and financing channels remains my priority.
I look forward to our discussion.