Real interest rate

Precious Metals And Commodities Are Entering A Bull Market That Could Last Over A Decade

Retrieved on: 
Thursday, May 13, 2021

As it turns out, GS projects that the Bull Market for gold will continue through 2021 and they gave a few reasons why.

Key Points: 
  • As it turns out, GS projects that the Bull Market for gold will continue through 2021 and they gave a few reasons why.
  • Goldman expects the falling US dollar to continue trending lower into 2021, which should help support gold prices.
  • "The breakdown of negative gold price changes and real rates correlation typically happens when the positive rates-dollar correlation disappears.
  • You should consider these factors in evaluating the forward-looking statements included herein, and not place undue reliance on such statements.

Precious Metals And Commodities Are Entering A Bull Market That Could Last Over A Decade

Retrieved on: 
Thursday, May 13, 2021

As it turns out, GS projects that the Bull Market for gold will continue through 2021 and they gave a few reasons why.

Key Points: 
  • As it turns out, GS projects that the Bull Market for gold will continue through 2021 and they gave a few reasons why.
  • Goldman expects the falling US dollar to continue trending lower into 2021, which should help support gold prices.
  • "The breakdown of negative gold price changes and real rates correlation typically happens when the positive rates-dollar correlation disappears.
  • You should consider these factors in evaluating the forward-looking statements included herein, and not place undue reliance on such statements.

Affordability Improved Amid Soaring Nominal House Prices, According to First American Real House Price Index

Retrieved on: 
Wednesday, March 31, 2021

Our Real House Price Index (RHPI) adjusts nominal house prices for purchasing power by considering how income levels and interest rates influence the amount one can borrow, said Fleming.

Key Points: 
  • Our Real House Price Index (RHPI) adjusts nominal house prices for purchasing power by considering how income levels and interest rates influence the amount one can borrow, said Fleming.
  • Indeed, a walk down house price memory lane shows us that nominal house prices alone are not always a good measure of affordability.
  • In the chart , nationwide nominal house prices, real house prices, and house-buying power are all indexed to January 1990.
  • The next release of the First American Real House Price Index will take place the week of April 26, 2021 for February 2021 data.

Isabel Schnabel: Paving the path to recovery by preserving favourable financing conditions

Retrieved on: 
Friday, March 26, 2021

Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at NYU Stern Fireside ChatThe pandemic has posed enormous challenges to monetary policy, which have varied over time.

Key Points: 

Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at NYU Stern Fireside Chat

    • The pandemic has posed enormous challenges to monetary policy, which have varied over time.
    • By offering to purchase large amounts of securities, central banks succeeded in restoring orderly trading conditions.
    • In doing so, we prevented the public health crisis from turning into a full-blown financial crisis, a risk that was particularly acute in the euro area.
    • This was reinforced, in a strong act of European solidarity, by the agreement on the EU Recovery and Resilience Facility.
    • The question facing the ECBs Governing Council at its meeting on 10December 2020 was how to best provide this support.
    • One was that the unprecedented fiscal and monetary policy support had succeeded in delivering highly favourable financing conditions.
    • The nominal euro area GDP-weighted yield curve stood at its lowest ever recorded level (left chart, slide 2).
    • The Governing Council responded to these conditions with a powerful commitment to preserve favourable financing conditions.

What distinguishes a policy of preserving favourable financing conditions?

    • The first is a departure from a policy that attempts to push interest rates even lower.
    • The benefits from reducing interest rates further from very low levels may still outweigh the costs in certain circumstances.
    • But when uncertainty is large and private demand constrained, monetary policy is like pushing on a string.
    • In such circumstances, monetary policy can best support the economy by ensuring that favourable financing conditions prevail for as long as needed.
    • The second characteristic is the way we deliver on our commitment to preserve favourable financing conditions.
    • We buy more when financing conditions are becoming less favourable, and we buy less when they are stable or improving.
    • Today, they are a means to an end: they are used to the extent necessary to deliver on our commitment to preserve favourable financing conditions.

Preserving favourable financing conditions: a reaction function

    • And what is the reaction function?
    • The other principle is that the favourability of financing conditions is a relative concept.
    • Conversely, an increase in real interest rates is not necessarily a sign that financing conditions are becoming less favourable.
    • These considerations are what distinguishes a policy of preserving favourable financing conditions from yield curve control.
    • The latter targets a fixed level of nominal yields with a view to increasing, rather than preserving, the degree of monetary accommodation.
    • These types of movement, if sizeable and persistent, make financing conditions less favourable as they are not accompanied by a corresponding increase in real equilibrium rates.
    • A firm commitment to favourable financing conditions therefore requires a certain minimum purchase volume to offset this effect on real interest rates.
    • Preserving favourable financing conditions therefore puts the drivers of changes in financing conditions, and their speed of adjustment, into the focus of our assessment.
    • In addition, changes in market-based financing conditions have to be assessed jointly with the likely future trajectory of the economy, in particular the inflation outlook.

Assessing recent market developments

    • Between the December decision and our most recent Governing Council monetary policy meeting on 11March, we saw a rapid increase in global and euro area nominal interest rates.
    • The factors that have caused a rise in risk-free interest rates have been largely benign in the euro area.
    • These movements should not be seen as reflecting a genuine reappraisal of the expected future path of inflation.
    • Term structure models suggest that much of the recent rise in nominal ten-year OIS rates reflects an increase in term premia which, in turn, likely reflects a rise in the inflation risk premium (right chart, slide 9).
    • In other words, markets have started to revise the balance of risks around the medium-term inflation outlook.
    • It is also unclear how firms will adjust their profit margins to make up for lost income and higher leverage.
    • Real rates up to a maturity of five years have even continued to reach new historical lows in recent weeks (left chart, slide 11).
    • Against this backdrop, the Governing Council announced that we would significantly step up purchases under the PEPP in the second quarter, in line with market conditions.

Conclusion

    • Preserving favourable financing conditions is a powerful policy response to the challenges we are currently facing.
    • It is a strong commitment to protect an exceptional degree of policy accommodation for as long as needed.
    • It signals our unwavering determination to offset the impact of the pandemic on the projected inflation path.
    • This promise is underpinned by a purchase envelope that is unprecedented in the history of the ECB.

Isabel Schnabel: Paving the path to recovery by preserving favourable financing conditions

Retrieved on: 
Friday, March 26, 2021

Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at NYU Stern Fireside ChatThe pandemic has posed enormous challenges to monetary policy, which have varied over time.

Key Points: 

Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at NYU Stern Fireside Chat

    • The pandemic has posed enormous challenges to monetary policy, which have varied over time.
    • By offering to purchase large amounts of securities, central banks succeeded in restoring orderly trading conditions.
    • In doing so, we prevented the public health crisis from turning into a full-blown financial crisis, a risk that was particularly acute in the euro area.
    • This was reinforced, in a strong act of European solidarity, by the agreement on the EU Recovery and Resilience Facility.
    • The question facing the ECBs Governing Council at its meeting on 10December 2020 was how to best provide this support.
    • One was that the unprecedented fiscal and monetary policy support had succeeded in delivering highly favourable financing conditions.
    • The nominal euro area GDP-weighted yield curve stood at its lowest ever recorded level (left chart, slide 2).
    • The Governing Council responded to these conditions with a powerful commitment to preserve favourable financing conditions.

What distinguishes a policy of preserving favourable financing conditions?

    • The first is a departure from a policy that attempts to push interest rates even lower.
    • The benefits from reducing interest rates further from very low levels may still outweigh the costs in certain circumstances.
    • But when uncertainty is large and private demand constrained, monetary policy is like pushing on a string.
    • In such circumstances, monetary policy can best support the economy by ensuring that favourable financing conditions prevail for as long as needed.
    • The second characteristic is the way we deliver on our commitment to preserve favourable financing conditions.
    • We buy more when financing conditions are becoming less favourable, and we buy less when they are stable or improving.
    • Today, they are a means to an end: they are used to the extent necessary to deliver on our commitment to preserve favourable financing conditions.

Preserving favourable financing conditions: a reaction function

    • And what is the reaction function?
    • The other principle is that the favourability of financing conditions is a relative concept.
    • Conversely, an increase in real interest rates is not necessarily a sign that financing conditions are becoming less favourable.
    • These considerations are what distinguishes a policy of preserving favourable financing conditions from yield curve control.
    • The latter targets a fixed level of nominal yields with a view to increasing, rather than preserving, the degree of monetary accommodation.
    • These types of movement, if sizeable and persistent, make financing conditions less favourable as they are not accompanied by a corresponding increase in real equilibrium rates.
    • A firm commitment to favourable financing conditions therefore requires a certain minimum purchase volume to offset this effect on real interest rates.
    • Preserving favourable financing conditions therefore puts the drivers of changes in financing conditions, and their speed of adjustment, into the focus of our assessment.
    • In addition, changes in market-based financing conditions have to be assessed jointly with the likely future trajectory of the economy, in particular the inflation outlook.

Assessing recent market developments

    • Between the December decision and our most recent Governing Council monetary policy meeting on 11March, we saw a rapid increase in global and euro area nominal interest rates.
    • The factors that have caused a rise in risk-free interest rates have been largely benign in the euro area.
    • These movements should not be seen as reflecting a genuine reappraisal of the expected future path of inflation.
    • Term structure models suggest that much of the recent rise in nominal ten-year OIS rates reflects an increase in term premia which, in turn, likely reflects a rise in the inflation risk premium (right chart, slide 9).
    • In other words, markets have started to revise the balance of risks around the medium-term inflation outlook.
    • It is also unclear how firms will adjust their profit margins to make up for lost income and higher leverage.
    • Real rates up to a maturity of five years have even continued to reach new historical lows in recent weeks (left chart, slide 11).
    • Against this backdrop, the Governing Council announced that we would significantly step up purchases under the PEPP in the second quarter, in line with market conditions.

Conclusion

    • Preserving favourable financing conditions is a powerful policy response to the challenges we are currently facing.
    • It is a strong commitment to protect an exceptional degree of policy accommodation for as long as needed.
    • It signals our unwavering determination to offset the impact of the pandemic on the projected inflation path.
    • This promise is underpinned by a purchase envelope that is unprecedented in the history of the ECB.

Making sense of consumers’ inflation perceptions and expectations – the role of (un)certainty

Retrieved on: 
Wednesday, March 24, 2021

Prepared by Aidan Meyler and Lovisa ReicheOther things being equal, when economic agents anticipate that inflation will increase, they perceive the real interest rate to fall.

Key Points: 


Prepared by Aidan Meyler and Lovisa Reiche

  • Other things being equal, when economic agents anticipate that inflation will increase, they perceive the real interest rate to fall.
  • Inflation expectations also play an important role in the wage and price-setting process and are thus an important determinant of future inflation.
  • Therefore, understanding the nature of economic agents inflation expectations and how they are formed is crucial for monetary policymakers.
  • This article analyses consumers inflation expectations using data available from the European Commission Consumer Survey (ECCS).
  • There are several ways of measuring inflation expectations: they can be derived from financial market instruments, surveys of professional forecasters and business or household surveys.
  • This article focuses on consumer inflation perceptions and expectations taken from the harmonised ECCS.
  • [3] This analysis helps address some of the more puzzling stylised facts of these inflation expectations, namely that: (a)the average perception/expectation has tended to be systematically above, although co-moving with, actual inflation; (b) there is an apparent negative correlation between inflation expectations and economic sentiment;(c) there is substantial heterogeneity both across countries and across individuals in terms of the levels of inflation expectations.
  • [4] Furthermore, we confirm that consumers that report being in a better financial situation and who have positive expectations about the economy as a whole are associated with lower inflation expectations, and that this also holds when controlling for sociodemographic factors.
  • [5] We also offer explanations for both the bias in quantitative inflation expectations vis--vis actual inflation and their negative relationship with economic sentiment.
  • Furthermore, those who have a negative attitude about the economy as a whole also tend to be more uncertain about the inflation outlook and to report higher inflation expectations.
  • Section2 provides an overview of aggregate euro area consumers inflation perceptions and expectations.
  • Section5 discusses how the (un)certainty framework helps explain reported inflation expectations, and Section6 concludes.

2 The nature of consumers’ inflation expectations

    • Consumers qualitative inflation perceptions and expectations have tended to broadly co-move with actual inflation.
    • The qualitative responses to the questions on inflation perceptions and expectations are summarised using a balance statistic.
    • The most noticeable divergence is in consumers inflation perceptions following the introduction of the euro notes and coins.
Chart 1

    Changes in euro area consumers’ qualitative inflation perceptions and expectations and actual HICP inflation (left-hand scale: balance statistics; right-hand scale: HICP inflation as percentages)
    • When asked to quantify their inflation perceptions and expectations, consumers, on average, tend to report significantly higher figures than actual inflation.
    • Chart 2 presents the quantitative inflation perceptions and expectations reported by euro area consumers in the ECCS.
    • For perceptions, the mean since 2004, at 8.7%, is substantially above the average HICP inflation over the same period (1.5%).
    • [7] The lower quartile (i.e.the 25th percentile) averaged 3.6%, which is also substantially above actual inflation.
    • The lower quartile has averaged 2.0%, which indicates that approximately 75% of consumers reported inflation expectations higher than 2%.
Chart 2

    Changes in euro area consumers’ quantitative inflation perceptions and expectations and different measures of inflation (percentages)
    • The peak correlation with actual inflation has tended to be slightly lagging for inflation perceptions and broadly contemporaneous for inflation expectations.
    • Table 1 shows that the contemporaneous correlation of quantitative expectations with different measures of HICP inflation over the period 2004-2020 is somewhat higher than for quantitative perceptions, while the reverse holds for the qualitative figures.
    • Overall, however, no single expectation or perception measure correlates more than the others with actual inflation across all HICP measures and time periods.
    • Over the most recent five-year period (the figures in brackets in Table 1), the correlation of the quantitative estimates with actual inflation is relatively low, except for food price inflation.
Table 1

    The contemporaneous correlation of consumers’ qualitative and quantitative inflation perceptions and expectations with various measures of inflation (correlation coefficients)

3 Looking at consumers’ inflation expectations through the lens of uncertainty

    • The apparent rounding observed in consumers quantitative inflation expectations points to uncertainty in reported inflation expectations.
    • A considerable share of euro area consumers reports their quantitative expectations (and perceptions) using round numbers (most notably multiples of 5 and 10), while other consumers report to single digits or even to decimals.
    • Chart 3 shows noticeable peaks at 0%, 5%, 10%, 15% and 20%, with a smaller distribution of respondents reporting to single digits.
    • We use the round numbers suggest round interpretations principle to identify the existence of an uncertainty channel which may influence reported inflation expectations.
Chart 3

    Histogram of responses from -10% to +50% (y-axis: frequency of response as percentages)
    • The uncertainty framework is flexible enough to help provide an understanding of average inflation expectations over the period 2004-2020, as well as in specific periods when inflation has been relatively high and relatively low respectively.
    • For instance, the left panel of Chart 4 shows the distribution of quantitative inflation expectations in July 2008 (when overall HICP inflation was 4.1%).
    • At this time, there were noticeable peaks at multiples of 10 as high as 50%, while the share of respondents reporting 0% inflation was relatively low.
    • Among those who reported to single digits or even more precisely, the modal answer was 3%-4%.
Chart 4

    Distribution of responses at specific points in time Histogram of responses from -10% to +50% (percentages)
    • Those reporting in digits and decimals can, on average, be considered more certain, whereas those reporting in multiples of five and ten can be considered uncertain.
    • The respective shares of each group in the overall survey population can be derived for each survey month.
    • [10] On average, approximately one-third of respondents are more certain, while two-thirds are more uncertain (report to multiples of 5 or 10).
Chart 5

    Increase in uncertainty during periods of economic distress Share of uncertain respondents (percentages)
    • While uncertain respondents may not precisely quantify inflation, they appear able to capture the broad developments in inflation.
    • The upper panel of Chart 6 shows that the modal expectations of certain consumers are not too far off, and evolve broadly along with, actual inflation.
    • Thus, even if their level of expected inflation is biased with respect to actual inflation, the changes over time correlate closely.
Chart 6

    Modal inflation expectations of the “certain” group and the “uncertain” group (percentages)

Box 1 Consumers’ inflation expectations during the COVID-19 pandemic – applying the uncertainty framework

    • During the early months of the first wave of the coronavirus (COVID-19) outbreaks and lockdowns in Europe, there was an extraordinary movement in consumers inflation expectations, in particular compared with that for perceptions.
    • In March and April 2020 consumers quantitative inflation expectations rose, while their quantitative perceptions fell slightly and, for the first time, mean expectations for future inflation were higher than perceptions of past inflation.
    • It is challenging to reconcile these movements in inflation perceptions and expectations between February and June with actual inflation developments.
    • It also stood at the same rate (0.6%) in June as in April, and thus cannot explain the reversion in perceptions or expectations.
    • These developments in food price inflation could therefore potentially partly explain the changes in expectations but not the changes in perceptions.
    • Viewing consumers quantitative inflation perceptions and expectations through the lens of uncertainty can help explain their apparently puzzling evolution.
    • Chart A shows the change in the share of consumers reporting specific inflation perceptions and expectations in April 2020.
Chart A

    Changes in inflation perceptions and expectations from March to April 2020 Changes in histogram of responses from -10% to +30% (percentage points)

4 What determines whether individuals are (un)certain?

    • Whether a consumer is certain about price developments can depend on sociodemographic characteristics and economic sentiment.
    • To analyse this, we look at the probability that a consumer is certain about inflation and try to explain this using a range of sociodemographic and economic sentiment variables.
    • [14] The sociodemographic variables include characteristics, such as age, level of formal education, gender and income quartile.
    • On average, and other things being equal, a higher income and higher level of formal education contribute positively to an individuals estimated probability of being certain.
Chart 7

    Estimated probability that a consumer is certain about inflation expectations – sociodemographics (percentages)
Chart 8

    Estimated probability that an individual is certain about inflation expectations– economic sentiment (percentages)
    • The probability that an individual is certain about inflation expectations differs significantly across euro area countries.
    • The upper panel of Chart 9 shows that those countries where consumers are estimated to be more certain also have a lower mean inflation expectation across the time periods.
    • This suggests that the certainty channel plays an important role in explaining the differences in reported inflation expectations across countries in our sample.
Chart 9

    Negative relationship between certainty and inflation expectations across countries (x-axis: estimated probability that a consumer is certain about inflation for a modal individual in each country; y-axis: mean inflation expectation (January 2004 – September 2020)) (x-axis: estimated probability that a consumer is certain about inflation for a modal individual in each country; y-axis: mean HICP (January 2004 – September 2020))

5 Does this (un)certainty framework help explain and foster greater understanding of inflation expectations?

    • The role of (un)certainty in consumers quantitative inflation expectations is estimated with a model.
    • First, the linear effects of sociodemographic and economic sentiment variables on quantitative inflation expectations are estimated.
    • [17] Moreover, to control for potentially different macroeconomic environments, actual inflation (HICP), inflation forecasts by Consensus Economics and GDP growth by country and time are incorporated.
    • At the aggregate level, this model replicates stylised facts on the impact of sociodemographics and economic sentiment on inflation expectations.
    • The fitted values from the model closely match the actual measured inflation expectations.
    • Using this model to estimate the inflation expectation of an average person (i.e.
    • mean values in all categories) and averaging across countries for the whole sample period yields a value close to the measured mean expectations (Chart 10, Panel a).
Chart 10

    Estimated inflation expectations – fitted versus survey results (percentages)
    • [19] Applying the above model to each group separately shows that sociodemographic and sentiment variables have a smaller impact on the inflation expectations of the certain group (Table 2).
    • The difference in inflation expectations between the certain and uncertain groups is visualised in Chart 10, panel b and estimated over all time periods separately.
    • These results also hold in a model version that controls for perceptions, given their strong link with expectations.
    • [20] However, it should be noted that even consumers who are certain overestimate inflation.
Table 2

    Contribution of “certainty” to the level of inflation expectations Magnitude of coefficients in the model (coefficients from a linear model with inflation expectations as the dependent variable)

6 Conclusion

    • Inflation (un)certainty is a channel that sheds light on some of the more puzzling aspects of reported quantitative inflation expectations.
    • First, the (un)certainty lens helps explain why we can observe high estimated aggregates despite rather low inflation.
    • This is because in conditions of uncertainty many consumers report rounded numbers, whereby they often quantitatively overestimate inflation.
    • Furthermore, the uncertainty channel is also a possible explanation for the negative correlation sometimes observed between the economic outlook and inflation expectations.
    • [22] We show that this correlation could reflect increased uncertainty, which, in turn, increases reported inflation expectations.

Can consumers’ inflation expectations help stabilise the economy?

Retrieved on: 
Wednesday, January 13, 2021

By Ioana Duca-Radu, Geoff Kenny and Andreas Reuter[1] Economists have argued that when interest rates set by policymakers cannot go any lower, the economy can be stabilised if consumers expect the rate of inflation to increase.

Key Points: 
  • By Ioana Duca-Radu, Geoff Kenny and Andreas Reuter[1] Economists have argued that when interest rates set by policymakers cannot go any lower, the economy can be stabilised if consumers expect the rate of inflation to increase.
  • In this article we review new evidence from a monthly survey of over 25,000 individual consumers across the euro area showing that consumers are indeed more ready to spend if they expect inflation to be higher in the future.
  • While generalised in the population, the stabilising effect is stronger when nominal interest rates are constrained at the lower bound.

Introduction

    • By lowering nominal interest rates central banks have sought to reduce also the real rate of interest, i.e.
    • the nominal interest rate adjusted for any anticipated inflation developments, and thereby to stimulate investment and consumption.
    • [2] However, when nominal interest rates reach their lower bound, the main factor that can further reduce the real rate of interest is a higher rate of expected inflation.
    • In line with this, policymakers have stressed the role of inflation expectations in the effective transmission to the economy of asset purchases and other non-conventional policies.
    • In this article, we review new evidence on this important issue from our recent study (Duca-Radu, Kenny and Reuter, 2020).
    • The survey provides on average 26,440 individual responses on a monthly basis that are highly representative of the populations across the euro area countries.

Readiness to spend and the expected change in inflation

    • Why would consumers readiness to spend be influenced by their recent experience of inflation?
    • In line with the above observation, we place at the centre of our analysis the difference between consumers expectation of future inflation and their own perception of current inflation.
    • A first look at the data shows that the proposed approach brings a dramatic reassessment of the link between expected inflation and readiness to spend.
    • Chart 1 portrays two scatter plots linking inflation expectations and consumers readiness to spend.
    • looking at the expected change in inflation (right hand-side chart), a much more stable and positive relationship with the readiness to spend is detected.
    • Chart 1 Readiness to spend, inflation expectations and the expected change in inflation (Y-axis: readiness to spend; x-axis: percentage points, inflation expectations (left-hand chart) or the expected change in inflation (right-hand chart))
    • One potential concern in such an analysis is that the strong positive correlation observed in the right-hand panel of Chart 1 reflects reverse causation running from consumption to the expected change in inflation and not vice versa.
    • For example, if respondents expect their own spending to correlate also with other consumers spending they might expect the overall economic situation to improve and, as a result, also expect stronger inflation in the future.
    • As a result, the response of spending to inflation expectations can be estimated whilst holding such additional factors constant.
    • Estimates using this model reveal very strong statistical evidence for the positive relationship highlighted in the right-hand panel of Chart 1.
    • This latter value points to an even stronger potential stabilisation role of higher inflation expectations relative to current perceptions about inflation when the lower bound is constraining nominal interest rates.
    • Equally, it points to the potentially stronger destabilising effects of a drop in expected inflation relative to current inflation perceptions in such an environment.
    • Holding perceptions about current inflation constant, a gradual 2.0 pp expected increase in inflation (e.g.

Results hold widely across the population and across countries

    • More disaggregated analysis reveals that the positive relationship between consumption and the expected change in inflation holds widely across nearly all euro area countries.
    • For example, the positive spending response is stronger for consumers in countries with higher financial literacy scores a result which suggests that the stabilising benefits might be augmented by policies aimed at increasing financial literacy.
    • Chart 3 depicts how the spending response differs according to the accuracy of consumers inflation expectations, where accuracy is assessed by how well consumers inflation expectations can predict the official inflation statistics.
    • Nevertheless, even the spending of consumers with very large absolute prediction errors (above 10.0 pp) responds positively to beliefs about future inflation.
    • Such results suggest that the stabilising benefits of higher inflation expectations might be augmented by policies aimed at increasing the publics knowledge about official inflation.
    • Chart 2 Spending response to inflation beliefs of optimistic and pessimistic consumers (Y-axis: change in the spending probability)


    Chart 3 Spending response to inflation beliefs by forecast accuracy (Y-axis: change in spending probability; x-axis: absolute mean prediction error)

Conclusions

    • Overall, the empirical evidence for the euro area reported here tends to support the potential economic stabilisation benefits of higher inflation expectations when interest rates are constrained.
    • Importantly, our study has not addressed key questions related to the transmission of central bank policies and policy communication to consumers inflation expectations.
    • Haldane and McMahon (2018), have pointed to the potential benefits of communication strategies that are targeted at specific groups.
    • In the case of the euro area, a new Consumer Expectations Survey[5] currently being piloted across six euro area countries will offer a useful research tool to further enrich knowledge on these important issues.

References

Prospects for euro area bank lending margins in an extended low-for-longer interest rate environment

Retrieved on: 
Thursday, November 26, 2020

In the wake of the pandemic, the economic outlook has deteriorated, the recovery is uncertain and interest rates are expected to remain at historical lows for even longer.

Key Points: 
  • In the wake of the pandemic, the economic outlook has deteriorated, the recovery is uncertain and interest rates are expected to remain at historical lows for even longer.
  • The persistently low interest rate environment can both support and dampen the profitability and resilience of euro area banks.
  • This special feature examines some aspects of how the low-for-even-longer interest rate environment may affect bank lending margins, and in turn banks ability to lend to the real economy and overall financial stability.
  • The compression of margins reflects the sluggish response to further policy rate cuts of deposit rates as they approach the zero lower bound.

1 Introduction

    • The low interest rate environment has featured heavily in debates on prospects for the euro area banking system, which faces persistently weak profitability.
    • That said, overall bank risk-taking was not judged to be particularly elevated, especially given the better capitalisation of banks since the crises earlier in the decade.
    • In the wake of the pandemic, the low interest rate environment is expected to persist even longer, driven by lower real interest rates.
    • Very low nominal interest rates have been a feature of the economic environment across advanced economies since 2009.
    • They reflect a decline in equilibrium interest rates, i.e.
    • Chart B.1 The phenomenon of very low real and nominal interest rates a feature since 2009 is set to persist in the wake of the pandemic
    • The first section focuses specifically on the impact of the real versus the nominal component of interest rates on net interest margins, returns and loan loss provisions.
    • It also investigates whether the adverse impact of falling interest rates on net interest margins worsens when nominal short-term rates are negative and when low rates persist for an extended period.
    • Given the finding of non-linearity around negative interest rates, the second section discusses the prospects for overcoming the zero lower bound on customer deposit rates.

2 The role of real and nominal rates in bank intermediation

    • The real rate component of interest rates may affect bank profitability separately from changes in inflation expectations.
    • Nominal interest rates consist of two components: the real interest rate and compensation for the loss of purchasing power over the life of a contract, which reflects the prevailing inflation expectations.
    • [2] An increase in real rates, especially long-term interest rates, tends to mirror a strengthening in the expected growth of the real economy.
    • Alternatively, it may capture changes in the creditworthiness of bank borrowers, which tends to worsen if real debt servicing costs increase and result in higher credit risk premia embedded in bank lending rates.
    • [3] The economic literature identifies a number of structural factors exerting downward pressure on real interest rates.
    • [5] Even outside of a low interest rate environment, these intermediation margins increase when interest rates are higher.
    • [6] Table B.1 The estimated impact of nominal and real rates on bank profitability
    • Notably, higher nominal interest rates driven by variation in inflation expectations are found to be particularly important for margins.
    • [7] The explicit distinction between changes in nominal interest rates due to variation in real rates and changes driven by higher inflation expectations is a key feature of this analysis.
    • Higher interest rates when driven by higher inflation expectations are found to lead to a significant increase in net interest margins.
    • Higher real long-term interest rates for a given level of inflation expectations tend to be associated with slightly lower net interest income.
    • [8] Higher real short-term rates support banks margins, reflecting the limited sensitivity of remuneration on transaction deposits to market conditions.
    • Lower nominal short-term interest rates squeeze margins more when short-term rates are low.
    • The results from including a quadratic term of the nominal short-term interest rate in the specification show that low starting values for interest rates result in nominal short-term rates having a steeper impact on banks net interest margins (see ChartB.2, left panel).
    • [9] Adding an interaction term between the short-term interest rates and a dummy for the period over which negative interest rates on excess reserves held in the ECBs deposit facility have been applicable reveals that the impact of nominal short-term interest rates on the net interest margin increases by a factor of 10 when short-term rates are negative compared with a positive starting point.
    • This is also consistent with there being a zero lower bound on the interest rates for retail deposits.
    • The impact of low interest rates on bank profitability may change over time, but in principle the effect of longevity can operate in both directions.

3 Prospects for the pass-through of negative interest rates to deposit rates

    • Since 2014 euro area banks have only gradually moved to charging negative interest rates on customer deposits.
    • Negative rates in this segment are observed only in some euro area countries (Germany, Italy, Cyprus, the Netherlands, Finland and Belgium).
    • Corporate deposits are subject to negative rates in both the longer-term and the overnight segments, the latter being by far the most relevant category.
    • A number of structural features of the economy may explain the relevance and persistence of the zero lower bound on deposit rates.
    • For corporate deposits, existing analyses illustrate that negative rates are more likely to be passed through by stronger banks.
    • Chart B.3 The distribution of NFC deposit rates Evolution of the distribution of NFC deposit rates, across banks (percentage points) Deposit rates versus share of large loans to NFCs (x-axis: percentage of total NFC loans; y-axis: percentage points)
    • Looking ahead, banks in the euro area may find it increasingly difficult to continue charging negative rates on a significant share of their deposits.
    • Market rates are expected to remain at historically low levels for a long time, largely due to developments in the structural factors underpinning the low-rate environment.
    • Consequently, the sluggishness by which banks charge negative deposit rates more extensively will have a continuing impact on their margins and profitability.

4 Conclusion

    • Prior to the pandemic, there was already a debate as to whether the balance between supportive and dampening effects of low interest rates on euro area bank profitability was changing.
    • The main supportive effects come from the positive impact of low interest rates on the economic outlook, decreasing loan losses due to improved borrower creditworthiness, and increasing intermediation volumes.
    • The dampening effects studied in this special feature, reflect the negative impact of low rates on net interest margins.
    • Expectations are now for historically low rates to remain for even longer, still driven largely by real interest rates.
    • This is especially likely if the pass-through of negative interest rates continues to remain sluggish.
    • Behind the aggregate improvement of risk-adjusted returns in recent years, the extent and drivers of recovery differ by portfolio type (see ChartA, upper panel).
    • At the same time, volumes increased most markedly for sovereigns and, to a lesser degree, for mortgage and NFC portfolios.
    • [16] Risk-adjusted returns decline in all three scenarios, but the largest declines are under the COVID-19 severe scenario (although scenarios, samples and methodologies have changed over time).
    • [17] In all cases, returns on the household consumer credit portfolio fall the most, driven by increases in the cost of risk.
    • Furthermore, in the COVID-19 central and severe scenarios, effective interest rates remain low and cannot offset the fall in returns.
    • For household mortgage lending, effective interest rates also fall, while the cost of risk rises.

Isabel Schnabel: COVID-19 and monetary policy: Reinforcing prevailing challenges

Retrieved on: 
Wednesday, November 25, 2020

SPEECHCOVID-19 and monetary policy: Reinforcing prevailing challengesSpeech by Isabel Schnabel, Member of the Executive Board of the ECB, at The Bank of Finland Monetary Policy webinar: New Challenges to Monetary Policy StrategiesNine 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.

Key Points: 


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

    Isabel Schnabel: COVID-19 and monetary policy: Reinforcing prevailing challenges

    Retrieved on: 
    Wednesday, November 25, 2020

    SPEECHCOVID-19 and monetary policy: Reinforcing prevailing challengesSpeech by Isabel Schnabel, Member of the Executive Board of the ECB, at The Bank of Finland Monetary Policy webinar: New Challenges to Monetary Policy StrategiesNine 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.

    Key Points: 


    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