Yield curve

Helsinki, 2 July 2019

Monetary Policy and Below-Target Inflation

Speech by Philip R. Lane, Member of the Executive Board of the ECB, at the Bank of Finland conference on Monetary Policy and Future of EMU

• I would like to thank the Bank of Finland for inviting me to speak at this conference in Helsinki today.
• [1] In my contribution, I wish to share some thoughts on the conduct of monetary policy in a low-inflation environment.
• This is a global topic that generates similar challenges for most of the central banks represented at this event.
• Furthermore, the effectiveness of the policy toolkit means that we can add further monetary accommodation if it is required to deliver our objective.

The ECB’s instruments and tools

• Excellent accounts of the history of ECB monetary policy are provided by Hutchinson and Smets (2017), Hartmann and Smets (2019) and Rostagno et al.
• As a summary device, Chart 1 shows some key interest rates and developments in excess liquidity in recent years.
• From mid-2014 onwards, net liquidity provision from refinancing operations and asset purchases has markedly increased.
• Chart 1 EONIA, key ECB interest rates and excess liquidity (lhs: bn; rhs: percentages per annum)
• While it is always possible to envisage a wider range of instruments, the current policy mix includes four elements: (i) pushing the policy rate into negative territory, (ii) forward guidance on the future policy path, (iii) the APP, and (iv) TLTROs.
• Importantly, these measures work as a package, with significant complementarities across the different instruments.
• Furthermore, the effectiveness of these tools also provides leeway for further easing if it is required.

Negative policy rate (deposit facility rate)

• The 2014 decision by the ECB to push the relevant policy rate (the deposit facility rate) into negative territory was a crucial policy innovation.
• Subsequent cuts have taken the deposit facility rate to its current level of minus 40 basis points.
• An important mechanism that reinforces the impact of negative interest rates relates to the way expectations about the future path of monetary policy are reflected in market interest rates.
• Via this re-evaluation, negative rates loosen the perceived lower bound on the future distribution of short-term interest rates.
• To illustrate the effectiveness of negative policy rates, ECB staff undertook a counterfactual exercise.
• They constructed the forward curve that would prevail in a scenario without either the negative interest rate policy or the forward guidance on the future path of the policy rates.
• Our negative policy rate thus contributes substantially to providing monetary accommodation.
• At the same time, it is also clear that there may be negative side effects.
• [5] Accordingly, the Governing Council will continue to assess the case for mitigating measures, which is especially relevant if further rate cuts are envisaged.

Forward guidance on interest rates

• Our interest rate forward guidance with its state-contingent and date-based legs has become the principal tool for adjusting the monetary policy stance, especially following the end of net asset purchases.
• This, in turn, allows interest rate expectations to adjust dynamically in a data-dependent manner, which results in automatic easing if the convergence path is delayed.
• The evidence shows that our enhanced forward guidance has been effective.
• Since the second half of 2018, when we enhanced our forward guidance on interest rates (and especially since the monetary policy meeting of the Governing Council in March 2019), the reassessment by investors of information regarding the outlook has led them to expect a somewhat longer horizon over which rates are more likely than not to remain unchanged.
• In March and June 2019, the Governing Council assessed that the risks to price stability warranted a recalibration of the date-based leg, thereby conveying the Governing Councils updated assessment of the direction that the ECBs key interest rates will have to follow.
• The Governing Council now expects to keep policy rates unchanged at least through the first half of 2020.
• Finally, the inherent flexibility in our forward guidance framework always allows for additional enhancements to ensure that inflation remains on a sustained adjustment path.

APP

• The significant stock of assets purchased through the APP and the subsequent reinvestments once net purchases ended in December 2018 have been providing substantial monetary accommodation to the euro area.
• My colleague Benot Cur recently provided a thorough assessment and Chart 4 and Chart 5 illustrate the contribution of the APP to the easing of financial conditions through the reduction of yields.
• [6] According to those estimates, after the last recalibration of the APP in June 2018, the ten-year bond yield would have been around 95 basis points higher in the absence of the APP.
• By absorbing duration risk from the market, investors require less risk compensation, which pushes down term premia and yields.
• Chart 4 Projected evolution of the PSPP portfolio of the four largest euro area countries in maturity-adjusted terms (bn ten-year equivalents)


Chart 5 Estimated effect of APP recalibration vintages on euro area ten-year term premium (basis points)
If warranted by our policy assessment, net purchases under the APP could be restarted in the future.[8] In the event of any resumption of net purchases, associated revisions to the framework of forward guidance would have to be considered in order to make sure that the different instruments continue to be tightly linked and that their synergies are maximised.

TLTROs

• The Governing Council recently decided to start a third series of TLTROs (TLTRO III) to help preserve favourable bank lending conditions and support the smooth transmission of monetary policy.
• The funding cost relief is direct for those banks that switch from more expensive options to TLTRO financing.
• The upshot of cheaper bank funding is higher credit volumes and lower lending rates to the wider economy via the bank lending channel.
• [9] Chart 6a Impact of TLTRO on lending rates (upper chart) and lending volumes (lower chart) (percentage points, deviations from September 2014)


Chart 6b Impact of TLTRO on lending volumes (notional stock, September 2014=1)
In fact, our experience with previous TLTROs (TLTRO I and II) was that these operations had a significant effect on funding costs, particularly in more vulnerable euro area countries. Moreover, the lower funding costs were passed through to customers. Particularly in vulnerable countries, banks that participated in TLTROs cut their lending rates by more than their non-participating peers (see Chart 6).

The policy package

• In assessing the impact of our policy package, we must also take into account that the instruments were designed to be complementary and mutually reinforcing.
• Let me give two examples to illustrate the role played by complementarities in our policy design.
• First, the negative interest rate policy has supported the portfolio rebalancing channel of the APP by encouraging banks to lend to the broad economy instead of holding onto liquidity.
• [11] Asset purchases provide a strong signal that policy rates will remain low for an extended period of time.
• Chart 7 Impact of ECB non-standard measures on the term structure of interest rates 2014-18 (percentage points per annum)


The improved financing conditions have made a considerable contribution to the macroeconomic performance of the euro area. A counterfactual exercise undertaken by ECB staff shows that growth and inflation would have been notably lower in the absence of our non-standard measures (see Chart 8 and Chart 9). [12] Chart 8 Contribution of ECB non-standard measures to real GDP growth 2014-18 (year-on-year percentage changes)
Chart 9 Contribution of ECB non-standard measures to HICP inflation 2014-18 (year-on-year percentage changes)

• That said, as the Governing Council has emphasised many times, in order to reap the full benefits from our monetary policy measures, it is important that other policy areas make a more decisive contribution.
• Moreover, the aggregate cyclical stance of fiscal policy plays an important role in determining the amplitude and duration of economic fluctuations.
• As noted by President Draghi in his Sintra speech, a cyclically-appropriate aggregate fiscal stance may be more easily achieved through a well-designed central fiscal capacity.

Central bank communication

• The ECB strategy makes the primary objective of price stability operational through the medium-term orientation of monetary policy.
• This medium-term orientation provides the necessary flexibility to combat excessive volatility in output and inflation in responding to shocks.
• The medium term refers to a time span that is long enough to be consistent with a central banks capacity to control inflation, taking into account the typical transmission lag.
• The horizon should be short enough for the public to be able to assess the performance of the central bank in delivering its inflation goal.
• However, the definition of the medium term cannot be reduced to a fixed interval: it must be interpreted as state-dependent.
• Chart 10 Euro area HICP inflation and inflation expectations (y-o-y percentage change)
• Maintaining the medium-term inflation goal as the guideline for households, firms and market participants in forming expectations also requires a consistent communication strategy, especially when the near-term track record of inflation outcomes has deviated from the objective.
• In part, this communication strategy is anchored by our forward guidance on policy measures, so that everyone understands that the conditional future policy path supports convergence to the aim.
• It is also supported by demonstrating agility, with the central bank communicating that it stands ready to adjust its policy measures at any time to avoid undue delay in returning to the inflation goal and combat any adverse shock to inflation dynamics.
• It is also crucial to the successful anchoring of inflation expectations that the central bank shows it is a learning organisation that is committed in its search for the most effective policy tools in delivering its mandate.
• In common with other central banks, the ECB must always be open to new ideas and new methods, drawing from internal and external research and examples of best practice from around the world.

Conclusions

• In the context of the euro area, the ECB has been active and creative in deploying non-standard measures, in addition to extending the range for the policy rate into negative territory.
• Our assessment is that this policy package has been effective and further easing can be provided if required to deliver our mandate.
• At the same time, an extended phase of below-target inflation poses a communication challenge in maintaining focus on the medium-term inflation goal.
• It is obvious that it is easier to demonstrate commitment to the target if the actual track record of inflation outcomes corresponds more closely to the declared objective.

References