Philip R. Lane: The compass of monetary policy: favourable financing conditions

Speech by Philip R. Lane, Member of the Executive Board of the ECB, at Comissão do Mercado de Valores Mobiliários 25 February 2021IntroductionIn my remarks today, I will set out some considerations for thinking about favourable financing conditions as the compass guiding monetary policy.

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星期五, 二月 26, 2021

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Economy, Money, Macroeconomics, Monetary policy, Inflation, Yield curve, Central bank, Business cycle, Interest rate, Euro, Quantitative easing, Credit channel

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

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

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

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

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

Chart 5

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

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

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.