Yield curve

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• b'Numbers presented throughout this document may not add up precisely to the totals in the tables and text.
• Percentages and percent changes are calculated on complete figures (including decimals); therefore, the document might contain immaterial differences in sums and percentages due to rounding.
• Investable cash includes current cash balances, and future coupons and redemptions\n10 Corresponds to theoretical reinvestment yields based on Q1 2021 asset allocation of asset yielding classes (i.e.
• fixed income, loans and real estate), according to current reinvestment duration assumptions and spreads, currencies, yield curves as of March 31, 2021\n'

Speech by Fabio Panetta, Member of the Executive Board of the ECB, at an online event organised by Bocconi University

• In 2020, with the pandemic raging, the direction of policy support was obvious and the choices facing policymakers were relatively narrow.
• Monetary and fiscal authorities everywhere intervened to support the economy on a massive scale.
• But in 2021, with the progress made on vaccine technology, policy choices have become less clear-cut.
• As such, it might be tempting to conclude that there is less need for monetary policy support.
• We will still face two prominent gaps that we need to close: the output gap and the inflation gap.
• At present, the risks of providing too little policy support still far outweigh the risks of providing too much.

Eliminating downside risks

• There is a good chance that a recovery will take hold in the latter part of this year.
• But that is not a justification for policies to run on neutral.
• First, in a dramatic crisis like this one, macroeconomic policymakers should not bank on the most favourable scenario materialising.
• As I have argued elsewhere, the pandemic has produced an asymmetric balance of risks, which requires an asymmetric reaction function.
• Just as we looked though temporary negative inflation in recent months, we will look through this transitory hump in inflation.
• And this shallow growth path remains vulnerable to a series of downside risks.
• This divergence will bring risks of its own: in fact, we are already seeing undesirable contagion from rising US yields into the euro area yield curve.
• The risks to private consumption growth are therefore substantial.

Chart 1 Household financial situation and savings

(change in percentage balance from January 2020 to January 2021)
• Given the weak financial starting point of many firms, investment is likely to only increase gradually and cautiously.
• [5] A risk management approach would therefore clearly call for policy to eliminate these risks and reinforce the central growth path.
• And, if we were to do too much and push the economy onto a stronger growth path, that would in fact be a welcome result.

Closing the gaps faster

• But the experience of the last cycle suggests that it is hard to lift inflation dynamics without demand testing potential more dynamically.
• Despite several years of robust economic growth, the euro area economy might still have been operating with significant economic slack even on the eve of the pandemic.

Chart 2 Pre-crisis and recent estimates of the output gap in the euro area

(% of potential output) Source: ECB staff calculations.
• In the decade after the Lehman crash, yearly domestic demand growth in the euro area was almost 2 percentage points lower on average than it had been in the previous decade, and it was much lower than that of our main trading partners (Chart 3).
• This contributed to compressing inflation persistently below our aim, leading to a significant price level gap (Chart 4).
• [6] That was not the case in the United States or the United Kingdom, where domestic demand stayed on a stronger trajectory.

Chart 4 Harmonised Index of Consumer Prices (HICP)

(all-items, January 1999=100)
• This clearly called for action, as reflected in the additional support we decided on in December.
• Boosting demand is also necessary to reduce hysteresis risks after the pandemic.
• [8] Policy should not accept hysteresis as a reality which imposes new supply constraints, but rather explicitly set out to test those constraints.
• [9] A tight job market also improves the outlook for future demand, thereby strengthening business investment.

Delivering the necessary policy stance

• So the challenge we face is how to deliver the necessary policy stance.
• Since the start of the pandemic, monetary policy in the euro area has gone through three phases.
• In the first phase the phase of fragmentation the flexibility of our pandemic emergency purchase programme (PEPP)[10] averted an unjustified widening of spreads which would have disrupted monetary policy transmission.
• In the second phase, the PEPP increasingly became a tool for steering the overall monetary policy stance.
• This essentially means more focus on anchoring key financial variables above all, lending rates and the yield curve as key indicators of the monetary policy stance.
• So, that constellation of financing conditions should be seen as the reference point for our policy moving forward.

Chart 5 Euro area real and nominal rates

• In this way, we can prevent a tightening of financing conditions which would otherwise lead to inflation remaining below our aim for longer.
• Eventually, firm commitment to steering the euro area yield curve may allow us to slow the pace of our purchases.
• But in order to reach that point, we must establish the credibility of our strategy by demonstrating that unwarranted tightening will not be tolerated.

From policy fatalism to policy coordination

• But counterfactual analysis shows that after the financial crisis and during the COVID-19 shock the ECBs expansionary policies have been highly effective.
• Without our policies, inflation and GDP growth would have been dramatically lower and many more people would have lost their jobs.
• Preserving favourable financing conditions will have a powerful effect on demand and inflation.
• However, given the fall of the natural rate of interest,[14] monetary policy is more effective if deployed in sync with other policies.
• Monetary, fiscal and structural policies must reinforce each other in order to cut slack and close the gap between saving and investment.
• Fiscal policies continue to be a key channel for transmitting monetary policy to the real economy[15] and they are expected to remain supportive in 2021.

Chart 6 Euro area real and potential GDP

(EUR billions)
• They need to target investment in technology, education and infrastructure, creating an environment that bolsters growth and supports the sustainability of debt.
• We have a joint interest in making the European economy more dynamic.
• [16] NGEU is an important tool precisely because it ensures that common spending triggers growth-enhancing reforms that subsequently benefit all.

Conclusion

• My main message today can be summed up with the title of a song by the electronic music duo Daft Punk[18]: Harder, better, faster, stronger.
• The harder we push to close the output and inflation gaps, the better the outlook for the euro area economy.
• Achieving this will require the right combination of monetary and fiscal support at the EU level, and it will require continued, determined reforms at the national level.

Speech by Philip R. Lane, Member of the Executive Board of the ECB, at Comissão do Mercado de Valores Mobiliários

25 February 2021

Introduction

• In my remarks today, I will set out some considerations for thinking about favourable financing conditions as the compass guiding monetary policy.
• First, I will explain the logic of employing the favourability of financing conditions as the compass for monetary policy.
• In assessing financing conditions, it is desirable to adopt a holistic approach, based on a multi-faceted set of indicators for both bank-based and market-based financing conditions.
• Accordingly, in the following sections, I next turn to the analysis of bank-based funding conditions, which is followed by the analysis of market-based financing conditions.

Favourable financing conditions as the compass

• The phrase favourable financing conditions intentionally puts the spotlight on a pivotal section of the transmission mechanism that links the basic monetary policy instruments controlled by central banks (policy rates, asset purchases and refinancing operations) to the ultimate objective of delivering the medium-term inflation aim.
• Under pandemic conditions, two threats to the efficiency of monetary policy can be clearly identified.
• First, frictions in financial intermediation may disrupt the transmission of monetary policy impulses to the financing conditions for key economic actors (households, firms and governments).
• In this context, a focus on preserving favourable financing conditions as the compass guiding monetary policy addresses both concerns.
• First, it emphasises that the central bank is committed to recalibrating its underlying policy instruments if it detects any threat to the favourability of financing conditions.
• Second, clear communication that the financing conditions directly relevant to households, firms and governments will remain favourable during the pandemic period reduces uncertainty and bolsters confidence, thereby encouraging spending and investment, and ultimately underpinning the economic recovery and inflation.

Chart 1

Realised and projected HICP inflation (year-on-year percentage changes, quarterly averages)
• In turn, vigorous inflation dynamics are only likely if the overall economic recovery is robust.
• The preservation of favourable financing conditions for an extended period of time helps to support inflation developments through multiple channels.
• [3] First, the commitment to preserving favourable financing conditions reduces financing uncertainty for banks, corporates, households and governments alike.
• Keeping favourable financing conditions in this environment could even accelerate the dynamics of the recovery, since better economic prospects combined with attractive financing conditions can fast-track consumption and investment.
• [4] In particular, in December, the Governing Council pledged that purchases under the PEPP will be conducted to preserve favourable financing conditions over the pandemic period.
• Overall, we need to assess indicators that provide information on the whole gamut of transmission from upstream stages to downstream effects.
• Other financial indicators also feed into the staff macroeconomic projections and are incorporated into the Governing Councils regular assessments of the appropriate monetary stance.

Bank-based financing conditions

• [5] The pandemic and the measures to contain the spread of the virus have severely disrupted economic activity and curtailed business revenues.
• The avoidance of adverse feedback loops between the real economy and financial markets is a central task for policy makers.
• In turn, banks have been able and willing to meet the strong demand for liquidity over the course of the pandemic.
• The euro area bank lending survey (BLS) confirms that high loan demand of firms was accommodated by banks, which met the demand for bridge financing despite the rapid worsening of economic prospects in the second quarter of 2020.
• Monetary, supervisory and fiscal policies have been central to supporting bank lending conditions since the onset of the pandemic in terms of volumes and lending rates, which are around historically low levels for both firms and households.
• [6] The favourable impact of the TLTRO III on bank lending conditions and lending volumes has been signalled clearly by banks in the BLS.

Chart 2

Changes in credit standards and demand for loans to euro area firms in 2020 (net percentages of banks reporting an easing (+)/tightening (-) of credit standards and an increase (+)/decrease (-) in loan demand; net loan flows in EUR billions)
• In the autumn, however, signals from the BLS pointed to a broad-based tightening in credit conditions, even though bank lending rates have remained at historically favourable levels.
• Banks attribute the tightening of bank lending conditions to the intensification of risks to creditworthiness and the prospect of possible loan losses in the future, especially as the pandemic has lasted longer than originally expected.
• While Chart 3 shows that the net tightening of credit standards on loans to firms remains moderate compared with the global financial and sovereign debt crises, it signals potential risks to future loan growth.

Chart 3

BLS bank lending conditions and loan growth to firms (left-hand scale: net percentages of banks reporting an easing (+)/tightening (-) of credit standards and an increase (+)/decrease (-) in loan demand; right-hand scale: percentages)
• It follows that the evolution of corporate vulnerabilities and their possible ramifications for the bank-intermediated financing conditions facing the real economy should be closely monitored.
• This adverse interaction would be reinforced if household spending were to weaken and thereby were to further dampen the prospects for firms.
• These upstream-downstream inter-connections underline the critical importance of market-based financing conditions for the entire economy, not just for those entities that directly raise funding in the capital markets.

Market-based financing conditions

• Even households and small businesses which finance themselves via banks rather than in the market incur changes in their cost of funding through the impact of market-based financing conditions on bank-based financing conditions.
• In addition, market-based financing conditions influence non-bank intermediation, since the costs and benefits to participants in this sector vary with shifts in returns on investment.
• [8] Ensuring that the risk-free yield curve remains at highly accommodative levels is a necessary (but not sufficient) condition for ensuring that overall financing conditions are supportive enough to counter the negative pandemic shock to the projected inflation path.
• As such, sovereign yields are a key element in determining general financing conditions in all sectors and jurisdictions across the euro area.

Chart 4

Bank and sovereign bond yields (daily; percentages per annum; x-axis: sovereign yields; y-axis: bank bond yields)

Chart 5

Corporate and sovereign bond yields (daily; percentages per annum; x-axis: sovereign yields; y-axis: corporate bond yields)
• In one direction, shifts in the OIS yield curve and the GDP-weighted sovereign yield curve are early indicators of changes in the downstream set of indicators.
• In the other direction, these yield curve indicators are responsive to re-calibrations of our primary monetary policy instruments.
• Our monetary policy measures can contribute to preserving the OIS yield curve and the GDP-weighted sovereign yield curve at favourable levels.
• Following a temporary disconnect at the onset of the pandemic in the spring of 2020, our monetary policy actions successfully restored a close co-movement between the OIS curve and the GDP-weighted sovereign yield curve, most notably through the market stabilisation function of the PEPP (Chart 6).

Chart 6

10-year GDP-weighted sovereign yield and 10-year nominal OIS rate in the euro area (percentages per annum)
• Chart 7 shows that there was a considerable lowering of the middle and long segments of these yields curves over the course of 2020.
• By mid-December, these curves were relatively flat compared to the short-term policy rate (the deposit facility rate).
• In the initial weeks of 2021, there has been a steepening of these curves.

Chart 7

Euro area risk-free OIS and GDP-weighted sovereign yield curves and the ECB’s deposit facility rate (y-axis: percentages per annum; x-axis: maturity in years)
• This assessment will vary over time, taking into account revisions to the economic and inflation outlook.
• The integrated nature of global financial markets also means that there are clear spillovers across different currency areas in terms of the underlying shocks driving bond yields.
• Such financial spillovers are especially consequential if economies are at different stages of the economic cycle.
• For any given level of nominal interest rates, a generalised increase in expected inflation provides a boost to inflation dynamics by reducing economy-wide real rates.
• Tracking the full set of inflation expectations across the range of economic actors (financial market participants, firms, households) is, of course, a demanding exercise.

Conclusions

• In this environment, ample monetary stimulus remains essential to preserve favourable financing conditions over the pandemic period for all sectors of the economy.
• By helping to reduce uncertainty and bolster confidence, this will encourage consumer spending and business investment, underpinning economic activity and safeguarding medium-term price stability.
• In particular, the purchases made under the PEPP will be conducted to preserve favourable financing conditions over the pandemic period.
• Accordingly, the ECB is closely monitoring the evolution of longer-term nominal bond yields.