Fabio Panetta: Asymmetric risks, asymmetric reaction: monetary policy in the pandemic

SPEECH

Asymmetric risks, asymmetric reaction: monetary policy in the pandemic

Speech by Fabio Panetta, Member of the Executive Board of the ECB, at the meeting of the ECB Money Market Contact Group

• Frankfurt am Main, 22 September 2020 It is a pleasure to speak to the Money Market Contact Group today.
• Money markets and central banks have an important relationship which, when it is working well, makes monetary policy more effective.
• Money market prices reflect expectations of our policy and the understanding of our reaction function.

The ECB’s policy response to the coronavirus (COVID-19) crisis

• In pursuing our price stability mandate, our policy response to the crisis had three goals.
• The first was to counter the downward impact of the pandemic on the projected path of inflation.
• The second was to ensure that all parts of the euro area had access to liquidity, which was crucial for weathering the lockdown.
• As a result of our policy measures, tail risks have been removed and systemic stress in the euro area has receded (Chart 1).
• Without the ECBs action, the economic consequences of the pandemic would have been dramatic; we estimate that more than one million additional jobs would have been lost.
• Fragmentation has receded substantially, as the decrease in the dispersion of sovereign bond yields shows.
• This has safeguarded the transmission of monetary policy, with money market rates reconnecting to the ECB policy rates and sovereign yields reconnecting to risk-free rates, as proxied by overnight index swap (OIS) rates.
• Chart 2 Euro area ten-year real rate (percentages per annum) Sources: Refinitiv and ECB calculations.
• Notes: The real rate is constructed by subtracting the ten-year inflation-linked swap rate (ILS) from the nominal ten-year OIS rate.
• The impact on lending conditions has been significant.
• Our monetary policy measures, complemented by appropriate countercyclical supervisory measures, are enabling banks to keep credit flowing to households and businesses.
• In July, the annual growth rate of loans to firms stood at 7%, more than double its level in February.
• Benefiting from these developments, industrial production and the Purchasing Managers Indices (PMIs) have rapidly improved, partly recuperating the previous losses (Chart 3).
• In this crisis, our independent monetary policy and fiscal policies in the euro area have also mutually reinforced each other, thereby increasing confidence.
• This is the opposite of what we saw during the sovereign debt crisis, when yields increased alongside deficits.
• Fiscal support to the economy also made our own policy more powerful.
• But active fiscal policy also complements monetary policy through other channels.
• So, insofar as monetary policy empowers fiscal policy and increases confidence, it also empowers its own effectiveness.

The current economic situation

• This was the explicit goal of our decision to expand and extend the PEPP in June.
• And our pandemic support measures are contributing to that goal.
• Inflation excluding the volatile components of food and energy, which plays an important role in our assessment, rises to only 1.1% in 2022.
• Turning to economic activity, the recovery remains partial and uneven; GDP is only expected to recover to pre-crisis levels by the end of 2022.
• Chart 4 Inflation expectations in the euro area SPF inflation expectations and 1y-in-4y ILS rate (percentages per annum) Sources: Bloomberg, Refinitiv, and ECB calculations.
• The path to recovery is also exposed to new adverse shocks such as a possible disorderly Brexit as well as a loss of momentum due to various emerging economic and financial headwinds.
• The appreciation of the euro is one factor that we need to watch closely with regard to its implications for the medium-term inflation outlook, particularly at a time when current and expected inflation rates are both very low.
• The services sector, in which momentum has recently slowed somewhat, is another source of concern.
• Looking ahead, job and wage uncertainty is likely to remain elevated and give rise to continued precautionary behaviour among households.
• Together with corporate balance sheet vulnerabilities, weak aggregate demand and ample spare capacity, this is likely to compress investment.
• This is not a normal recession, and we will not see a normal recovery without appropriate policies.

Future policy calibration

• In these difficult circumstances, our policy must remain forward-looking, and there are two key elements to this.
• First, we need to constantly reassess whether the policy support we are providing and the calibration of our instruments are adequate to address the evolving shocks I have described and to achieve our objective of bringing inflation back to our medium-term aim in a sustained manner.
• If we encounter shocks that compress demand and pose additional threats to price stability, our reaction function is clearly spelled out: a policy response is necessary and forthcoming.
• The second element of a forward-looking policy response relates to how we assess and react to the balance of risks.
• Faced with such a sizeable downward skew, there is a strong case for our reaction function to be asymmetric, as the risks of a policy overreaction are much smaller than the risks of policy being too slow or too shy to react and the worst-case scenarios materialising.
• For as long as the growth and inflation outlook are at risk, monetary policy support will have to remain substantial, and if those risks to the outlook rise, our policy impulse will have to rise in tandem.


This is particularly important for countries with weaker economies and high debt-to-GDP ratios. For these countries, the sizeable funding provided at the European level presents a unique opportunity to address concerns of competitiveness and long-term sustainability. Growth will be the only solution to the accumulation of public and private debt.

Conclusion