Macroeconomic policy

Meeting of 28-29 October 2020

Account of the monetary policy meeting of the Governing Council of the European Central Bank held in Frankfurt am Main on Wednesday and Thursday, 28-29 October 2020

1. Review of financial, economic and monetary developments and policy options

Financial market developments

• Ms Schnabel reviewed the financial market developments since the Governing Councils previous monetary policy meeting on 9-10 September 2020.
• Financial markets had been driven by two opposing forces.
• The degree of accommodation currently embedded in euro area sovereign bond markets was practically unprecedented since the global financial crisis, both in its scale and its breadth across countries.
• Market participants had pointed to three main reasons to explain why the spreads had fallen further.
• There had been a strong negative correlation between euro area sovereign spreads and US stock price developments in the weeks before the current meeting.
• At present, euro area firms cash coverage was nearly four times higher than at the height of the global financial crisis.
• Finally, growing excess liquidity was increasingly putting downward pressure on the term money market and commercial paper rates.
• All in all, financial market conditions remained very favourable across market segments, but vulnerabilities remained in the face of the exceptionally high uncertainty surrounding the future evolution of the pandemic-related crisis.

The global environment and economic and monetary developments in the euro area

• Mr Lane reviewed the global environment and recent economic and monetary developments in the euro area.
• Regarding the external environment, the global economy had come back rapidly early in the third quarter, after the end of the lockdowns.
• Developments in the global composite output Purchasing Managers Index (PMI), excluding the euro area, indicated that the recovery in activity was quite strong up to July but had flat-lined in September.
• Retail sales had recovered strongly around the world, while global consumer confidence had risen from its lowest level but still remained very weak.
• The euro had remained broadly stable against the US dollar (+0.4%), which continued to have a unique role in global trade, and in nominal effective terms (+0.2%) since the September meeting.
• Turning to the euro area, output had rebounded strongly in the third quarter of 2020.
• The latest data supported the view that the recovery had been losing steam in the euro area.
• With respect to euro area labour markets, employment was expected to contract further and a large share of jobs were at risk.
• The euro area unemployment rate, which had increased from 7.2% in February to 8.1% in August, likely underestimated the ongoing adjustment in the euro area labour market.
• Regarding wage growth, euro area compensation per employee growth and compensation per hour growth had diverged strongly due to large changes in hours worked.
• Risk asset markets were largely unchanged despite significant intra-period fluctuations and, overall, euro area financial conditions remained broadly stable.

Monetary policy considerations and policy options

• Activity in the services sector was being hit the hardest, since it was most affected by the renewed restrictions on mobility and social interaction.
• Household consumption was expected to stay subdued, with the precautionary saving motive reinforced by the resurgence of the pandemic and its impact on employment and incomes.
• Weaker balance sheets and increased uncertainty about the economic outlook were weighing on business investment.
• Moreover, services inflation was expected to remain low, since the services sector was the most exposed to the ongoing intensification of containment measures.
• After a long period of relatively benign conditions, in the most recent data financial markets were pricing a more pessimistic pandemic outlook.
• While banks indicated that their funding and balance sheet conditions remained supportive, higher risk perceptions were weighing on loan creation.
• The monetary policy measures taken in response to the pandemic had been effective and efficient in stabilising financial markets and supporting financing conditions for households and businesses.
• Pending that information, Mr Lane proposed leaving the overall monetary policy stance unchanged and reconfirming the full set of existing monetary policy measures.

2. Governing Council’s discussion and monetary policy decisions

Economic and monetary analyses

• With regard to the economic analysis, members generally agreed with the assessment of the current economic situation in the euro area and the risks for activity provided by Mr Lane in his introduction.
• Incoming data and survey results signalled that the euro area economic recovery was losing momentum more rapidly than expected.
• Moreover, weaker balance sheets and increased uncertainty about the economic outlook were weighing on business investment.
• However, the momentum had slowed more recently and downside risks were related to increasing COVID-19 infection rates globally and to geopolitical factors.
• Since the Governing Councils September monetary policy meeting, the exchange rate of the euro had remained broadly stable both against the US dollar and in nominal effective terms.
• Turning to euro area developments, members underlined that there had been both positive and negative news since the last monetary policy meeting.
• Euro area real GDP had contracted by 11.8%, quarter on quarter, in the second quarter of 2020.
• However, the strength of the rebound might also have reflected that countries had eased containment measures too much too soon.
• As in March, the economic situation was once again changing rapidly.
• The euro area economic outlook was seen to depend crucially on the effectiveness of administrative measures and the infection dynamics of the pandemic, with the magnitude and duration of a further downturn being very uncertain.
• It was also remarked that the rate of infections appeared to be more relevant for economic activity than the stringency of containment measures, which varied considerably.
• Once the impact of the pandemic faded, a recovery in demand, supported by accommodative monetary and fiscal policies, would put upward pressure on inflation over the medium term.
• According to the survey, banks cost of funds and balance sheet situation had not contributed to the tightening, underscoring the positive impact of monetary policy support on bank funding conditions.

Monetary policy stance and policy considerations

• At the current juncture, members viewed the monetary policy stance as highly accommodative and appropriate.
• It was stressed that monetary policy had to aim to preserve favourable financing conditions in the future in order to support economic activity.
• Against this backdrop, members supported the proposal by Mr Lane to leave the overall monetary policy stance unchanged and to reconfirm the full set of existing monetary policy instruments.
• It was noted that taking monetary policy decisions in December would be consistent with prevailing market expectations.
• The PEPP was proving successful in stabilising market conditions and reducing fragmentation, as well as easing the monetary policy stance.
• While there was wide agreement on the need to signal the necessity of recalibrating the ECBs monetary policy instruments at the December monetary policy meeting, it was cautioned that the Governing Council should not pre-commit itself to specific policy actions.
• In this context, it could be emphasised that monetary policy was removing obstacles to the expansion of fiscal policy by supporting favourable financing conditions and the proper functioning of financial markets.
• In this way fiscal and monetary policy reinforced each other in the current circumstances, with monetary policy increasing its own effectiveness by empowering fiscal policy and fostering confidence.

Monetary policy decisions and communication

• Taking into account the foregoing discussion among the members, upon a proposal by the President, who ascertained that the decisions and proposed communication were supported by all members, the Governing Council took the following monetary policy decisions:
  1. The interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility would remain unchanged at 0.00%, 0.25% and -0.50% respectively. The Governing Council expected the key ECB interest rates to remain at their present or lower levels until it had seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within its projection horizon, and such convergence had been consistently reflected in underlying inflation dynamics.
  2. The Governing Council would continue its purchases under the pandemic emergency purchase programme (PEPP) with a total envelope of €1,350 billion. These purchases contributed to easing the overall monetary policy stance, thereby helping to offset the downward impact of the pandemic on the projected path of inflation. The purchases would continue to be conducted in a flexible manner over time, across asset classes and among jurisdictions. This allowed the Governing Council to effectively stave off risks to the smooth transmission of monetary policy. The Governing Council would conduct net asset purchases under the PEPP until at least the end of June 2021 and, in any case, until it judged that the coronavirus crisis phase was over. The Governing Council would reinvest the principal payments from maturing securities purchased under the PEPP until at least the end of 2022. In any case, the future roll-off of the PEPP portfolio would be managed to avoid interference with the appropriate monetary policy stance.
  3. Net purchases under the asset purchase programme (APP) would continue at a monthly pace of €20 billion, together with the purchases under the additional €120 billion temporary envelope until the end of the year. The Governing Council continued to expect monthly net asset purchases under the APP to run for as long as necessary to reinforce the accommodative impact of its policy rates, and to end shortly before it started raising the key ECB interest rates. The Governing Council intended to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when it started raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.
  4. The Governing Council would also continue to provide ample liquidity through its refinancing operations. In particular, the third series of targeted longer-term refinancing operations (TLTRO III) remained an attractive source of funding for banks, supporting bank lending to firms and households.

• By Elena Durante, Annalisa Ferrando, and Philip Vermeulen[1] We set out to analyse the monetary policy transmission mechanism by documenting how the annual investment of more than one million firms in Germany, Spain, France and Italy responded to monetary policy shocks between 2000 and 2016.
• This confirms that monetary policy is affecting firms investment through two different channels.
• On the other hand, as young firms are more likely to face financing constraints, their stronger than average reaction can be explained by the balance sheet channel of monetary policy transmission.

Introduction

• Monetary policy affects firms investment through both an interest rate channel and a balance sheet channel.
• First, through the interest rate channel, monetary policy can affect firms demand for capital as an input into the production process.
• This is because interest rates affect decisions on saving or investing and can boost aggregate demand.
• The external finance premium is the difference between the cost of borrowing funds externally and generating them internally.
• Another reason why the impact on firms investment varies is the height of the external finance premium they face.
• This article explains how we analyse these two channels of monetary policy transmission in the euro area, i.e.
• by documenting the heterogeneous reaction of firms investment to monetary policy shocks (Durante, Ferrando and Vermeulen, 2020).

Data and estimation method

• We use firm-level data from the four largest economies in the euro area (Germany, Spain, France and Italy) to construct a large and rich dataset covering more than one million firms throughout 2000-16.
• As a proxy for the euro area policy rate we use the high-frequency monetary policy shock series from Jarociski and Karadi (2020).
• Since firm-level investment data are annual, we construct an annual monetary policy shock data series by aggregating the monthly shocks into twelve-month totals.
• We split the firms into different groups, based on what we already know about firms being affected differently by different transmission channels.
• Younger firms have shorter credit histories and should therefore be more vulnerable than older ones to any tightening of credit conditions.

Findings

• how firms investment reacts to a tightening of monetary policy.
• The investment rate of the average firm does not react initially, but drops by 3.4 percentage points in the year following the monetary policy shock.
• In the second year after the shock, the investment rate remains at this lower level.
• Chart 1 Average investment reaction to a monetary policy shock
• firms below 10 years of age, react more strongly to a surprise than the average firm.
• Similarly, firms that produce durables react more strongly than firms providing services.
• Chart 2 illustrates that a combination of these characteristics leads to substantial differences in firms reactions to monetary policy.
• One year after the surprise, the investment rate of young firms in the durables sector drops by 5.0 percentage points.
• [2] Mature firms, between 10 and 20 years of age, exhibit a reaction within those two extremes (4.4 percentage points for mature firms producing durables and 2.9 percentage points for mature firms providing services).

Conclusions

• In the aftermath of a monetary policy shock, firms that produce durables cut back their investment more than firms providing services.
• Young firms also react more, indicating that the balance sheet channel of monetary policy is having an impact.
• Ultimately, these findings provide a deeper understanding of the transmission of euro area monetary policy to the real economy.
• They point to important differences across firms a feature that is not yet routinely embedded in the standard macroeconomic models.

References

SPEECH

COVID-19 and monetary policy: Reinforcing prevailing challenges

Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at The Bank of Finland Monetary Policy webinar: New Challenges to Monetary Policy Strategies

• Nine months into one of the most severe crises since World War II, we are still in the early stages of understanding the pandemics full ramifications.
• Some sectors of our economies may never return to their previous size.
• Central banks may have to change how they pursue their mandates in the face of evolving consumer preferences and changing technologies.
• Predicting the direction and scope of these shifts for monetary policy is inherently difficult.
• At the ECB, we are doing this as part of our ongoing monetary policy strategy review.

COVID-19 and risks to price stability

• Let me explain each of these challenges in turn, starting with the meaning of price stability in times of low inflation.
• In 2003, when the Governing Council conducted the last review of its monetary policy strategy, it defined price stability as being consistent with consumer price inflation of below, but close to, 2% over the medium term.
• It agreed on this definition after a long period in which too high rather than too low inflation was the main predicament central banks were facing.
• Over the past few years, however, inflation has fallen short of our aim.
• Globalisation, for example, together with significant advances in the way manufactured goods are produced, has made many consumer goods cheaper over time.
• An economy paralysed by the pandemic has pushed underlying inflation the rate of price change of less volatile goods and services to a new historical low of 0.2% in October (see slide 2).
• Some of these price developments may prove temporary as the economy recovers from the crisis.
• [3] A longer life expectancy can induce people to save more to smooth consumption over a longer period of time.
• The parallel decline in trend productivity growth since the 1970s is likely to have added to price stagnation.
• Higher output per hour is a necessary precondition for higher sustainable wages, incomes and, ultimately, prices.
• But they can, and should, make sure that the operationalisation of their mandates the way they define and pursue price stability leaves no doubt that too low inflation is as much a concern to society as too high inflation.
• Central banks can cater for such risks in their monetary policy frameworks by acting with the same determination to downward and upward deviations from their inflation aims.
• This is why we are already today stressing our commitment to symmetry in our introductory statements summarising our monetary policy decisions.

The effectiveness of monetary policy in a low rate environment

• When the pandemic broke out in late February, we honoured this commitment by reacting forcefully to the rapidly emerging downside risks to price stability.
• The pandemic emergency purchase programme, or PEPP, has been at the heart of our policy response.
• [4] By stabilising market conditions at a time of exceptional uncertainty and demand for safety, the PEPP acted as an important circuit breaker that stopped the pandemic from turning into a full-blown financial crisis (see slide 4).
• Its strong impact on the economy was in line with a rich literature that suggests that monetary policy is most effective during periods of market turmoil or when the economy is in a severe recession.
• [5] In these circumstances, a tightening of financial conditions damages the economy more severely due to a negative multiplier effect (see left chart slide 5).
• Monetary policy that acts to offset a tightening in financial conditions is then highly effective.
• [6] It is likely that this state-contingent effectiveness of monetary policy is also at play in current times.
• Heightened uncertainty, in turn, is likely to weaken the willingness and ability of firms and households to take full advantage of historically loose financial conditions.
• [7] In these situations, monetary policy cannot unfold its full potential.
• An important question in this debate is whether and how monetary policy transmission changes in the vicinity of the effective lower bound, and how this might affect the interaction between monetary and fiscal policy also outside crisis times.
• At the core of these models is the Euler equation, or the IS curve, which provides two fundamental hypotheses on which policy transmission is built.
• The first is the interest rate hypothesis the belief that aggregate demand reacts linearly to changes in real interest rates.

Monetary policy and the interest rate hypothesis

• The interest rate hypothesis needs closer inspection on three grounds.
• [9] First, an emerging literature suggests that monetary policy transmission may not be linear in the level of the interest rate.
• [12] All else equal, the lower the pass-through of interest rate changes to bank deposit rates, the smaller the effects of monetary policy on aggregate demand.
• [15] Recent experience suggests that money illusion may not only change the nature of the interest rate channel, it may also expose central banks to widespread criticism.
• [16] Many people may be surprised to learn that negative real interest rates are not a new phenomenon.

The expectations hypothesis

• This bias in peoples perception brings me to the second hypothesis the expectations hypothesis.
• When policy space is limited, expectations become the main driver of monetary policy transmission in New Keynesian models.
• This is why many central bank scholars have been concerned about the gradual fall in market-based inflation expectations in recent years.
• First, a large part of the fall in market-based inflation expectations can be explained by a fall in the inflation risk premium (see left chart slide 7).
• Empirical evidence suggests that such indicators can often provide only little additional forward-looking information about inflation, even for a horizon of only one to two years ahead.
• [17] This raises the question of whether inflation expectations of households and firms may be more relevant than those of the market for shaping macroeconomic outcomes in line with the expectations hypothesis.
• [19] For example, in surveys a significant fraction of consumers report very high inflation expectations often in excess of 10%.
• But a limited understanding of actual levels does not necessarily stop people from acting on their beliefs.
• They find either no evidence of inflation expectations affecting consumption decisions or, more disturbingly, even suggest that higher inflation expectations could lower rather than raise consumption.
• [21] One interesting pattern that can help explain these findings is that rising inflation expectations often seem to go hand-in-hand with expectations of lower incomes and lower economic growth (see right chart slide 8).
• [22] These findings suggest that individuals are far from being as rational and forward-looking as our canonical models assume.
• [24] Bounded rationality may hence limit the efficacy of policies geared towards boosting inflation expectations, all the more so as new empirical evidence highlights that most households are very hesitant about adjusting their long-term inflation expectations in response to news.
• First, fiscal policy has become more important as a macroeconomic stabilisation tool, also once we leave the pandemic behind us.
• New research demonstrates that trust has a tangible impact on households inflation expectations.
• We know that people once inflation is low care more about employment, which is part of the US Federal Reserves mandate.
• But it is much harder to explain why inflation of 2% is better than 1%.

Low inflation and the design and calibration of policy instruments

• But what we learn from our analysis of how monetary policy transmission to the real economy may change in a low interest rate environment may ultimately also affect the way we calibrate and design our policy instruments, as well the horizon over which we want to achieve our inflation aim.
• The first is that monetary policy faces constraints.
• For example, we may not know precisely where the effective lower bound lies, but we know that there is one.
• Exempting a portion of excess reserves from negative rates, or rewarding lending activities at rates below our main policy rate, have been effective instruments in stretching our boundaries.
• The second challenge relates to the unintended side effects of monetary policy.
• Money illusion, for example, may push house prices increasingly away from fundamentals, despite real interest rates not being extraordinarily low.
• A third and complementary aspect is the horizon over which we want to bring inflation back to our aim.

Conclusion

SPEECH

Monetary policy in a pandemic emergency

Keynote speech by Christine Lagarde, President of the ECB, at the ECB Forum on Central Banking

• Frankfurt am Main, 11 November 2020 Let me begin by welcoming all of you to this years ECB Forum on Central Banking.
• Regrettably, we cannot be together in Sintra this time, but I trust that this virtual environment will be no less conducive to challenging ideas and productive debate.
• The purpose of this years conference is to examine the challenges facing central banking in a shifting world.
• Actually, the largest shift central banks are facing today may well turn out to be the pandemic itself.

A highly unusual recession

• The deliberate shutdown of the economy triggered by the COVID-19 pandemic has produced a highly unusual recession.
• In a regular recession, manufacturing and construction are typically hit harder by the cyclical downturn, while services are more resilient.
• Compare our experience in the first half of this year with the first six months following the Lehman crash.
• After Lehman, manufacturing contributed 2.8 percentage points to the recession and services contributed 1.7 percentage points.
• But this year, the loss was 9.8 percentage points for services and much less, 3.2 percentage points, for manufacturing.
• First, research finds that the recovery from a services-led recession tends to be slower than from a durable goods-led recession, as services create less pent-up demand than consumer goods.
• [3] So, from the outset, this unusual recession has posed exceptionally high risks.
• More than ever before, macroeconomic, supervisory and regulatory authorities have dovetailed and made each others efforts more powerful.

Policy responses to the pandemic

• There are two main ways in which we have adapted the ECBs policy to the pandemic: via the design of our tools and via the transmission of our monetary policy.
• The PEPP in particular has the dual function of stabilising financial markets and contributing to easing the overall monetary policy stance, thereby helping to offset the downward impact of the pandemic on the projected path of inflation.
• The stabilisation function of the PEPP is ensured by its flexibility, which is crucial given the unpredictable course of the pandemic and its uneven impact across economies.
• [5] At the same time, the nature of the pandemic also affects the transmission of monetary policy.
• [6] In these circumstances, it is crucial that monetary policy ensures favourable financing conditions for the whole economy: private and public sectors alike.
• Indeed, these are the times when fiscal policy has the greatest impact, for at least two reasons.
• First, fiscal policy can respond in a more targeted way to the parts of the economy affected by health restrictions.
• And in this way, by brightening economic prospects for firms and households, fiscal policy can help reinvigorate monetary transmission through the private sector.

The risk of an unsteady recovery

• But regrettably the economic recovery from the pandemic emergency could well be bumpy.
• We are seeing a strong resurgence of the virus and this has introduced a new dynamic.
• So the recovery may not be linear, but rather unsteady, stop-start and contingent on the pace of vaccine roll-out.
• In the interim, output in the services sector may struggle to fully recover.
• Indeed, services were already showing a declining trend before the latest round of restrictions: the services PMI fell from 54.7 in July to 46.9 in October.
• And while manufacturing has so far remained relatively resilient, there is a risk of the recovery in manufacturing also slowing once order backlogs are run down and industrial output becomes better aligned with demand.
• In this situation, the key challenge for policymakers will be to bridge the gap until vaccination is well advanced and the recovery can build its own momentum.
• Supervisory authorities are working to ensure that banks can continue to support the recovery by readying them for a potential deterioration in asset quality.

The outlook for monetary policy

• So what is the role of monetary policy in this response?
• Continued policy support is therefore necessary to achieve our inflation aim.
• In these conditions, it is vital that monetary policy underpins inflation dynamics by supporting demand and preventing second-round effects, where the negative pandemic shock to inflation feeds into wage and price-setting and becomes persistent.
• To that end, the best contribution monetary policy can make is to ensure favourable financing conditions for the whole economy.
• First, while fiscal policy is active in supporting the economy, monetary policy has to minimise any crowding-out effects that might create negative spillovers for households and firms.
• Second, monetary policy has to continue supporting the banking sector to secure policy transmission and prevent adverse feedback loops from emerging.
• In other words, when thinking about favourable financing conditions, what matters is not only the level of financing conditions but the duration of policy support, too.
• They are therefore likely to remain the main tools for adjusting our monetary policy.

Conclusion