How can monetary policy curb inflation

Causes of monetary policy measures and their effects - an inventory

Speech by Yves Mersch, Member of the Executive Board of the ECB, at Euro Finance Week, FAROS Institutional Investors Forum, Frankfurt, November 17, 2016

"Knowledge of the causes leads to knowledge of the results"(Marcus Tullius Cicero - Causarum enim cognitio cognitionem eventorum facit. Topica 67).

The financial industry is facing enormous change. Many of the changes are intentional and positive. But far from all. In order to be able to better understand the individual aspects and their interrelationships, I am going into more detail today about the causes of our monetary policy measures and their effects. The policy of the European Central Bank (ECB) is often cited as the cause of the current problems in the banking and financial sector. It quickly becomes clear that such a conclusion does not go far enough. Getting to the root causes of our actions makes it easier to understand how we can return to normalization of monetary policy.

Causes: Low natural interest rates

Let's start with the causes. Why are interest rates so low?

The growth trend in many developed economies has been declining not just since the crisis, but for several decades. There are many reasons for this, which I do not want to go into in detail here. The fact is, slower growth has resulted in lower long-term interest rates.

In this environment there is a risk of a self-reinforcing downward spiral. Because of course these developments do not go unnoticed by the economic players; their expectations are clouding over. If a company expects less demand, it will be less willing to make large investments.

In addition, aging societies, as we find them in numerous developed economies, not only have to make do with a reduced labor supply, but also have to make greater savings. In the meantime, this has meant that we have excess savings and the need for secure investment opportunities is becoming scarce. So less is invested and more savings are made. This investment strike is intensified if the public sector - where there is room for maneuver and demand - invests less than is necessary to maintain macroeconomic substance alone.

This dynamic has led to a decline in the natural interest rate - that is, the real interest rate at which saving and investing are in equilibrium, in a normally busy economy in which there is no upward or downward pressure on inflation.

The natural interest rate plays an important role in our monetary policy. If the key interest rate is below the natural interest rate, monetary policy has a stimulating effect on the economy by creating an incentive for consumption and investment. Conversely, if key interest rates are higher than the natural interest rate, demand is dampened and thus also price increases.

In the current environment, the ECB has brought the market interest rate below the level of the natural interest rate. Accordingly, the key interest rate has been zero since March of this year and the interest rate for the deposit facility at -0.4%.

Had we not done this, constant nominal interest rates would have led to higher real interest rates as inflation rates fell and further weakened the already anemic growth. This would have increased the risk of deflation.

So we had to act in order to remain true to our mandate to ensure price stability.

However, we cannot lower our interest rates indefinitely. At a certain level, for example, it becomes more attractive for market participants to hold cash - despite the associated costs - than to pay negative interest.

Even if this point has not yet been reached, we should keep in mind that further rate cuts in negative territory may not be linear. The reactions of people in extreme situations cannot be planned on the drawing board.

But we can also influence market rates in other ways. With our security purchases, for example, we shifted the yield curve downwards. And by offering long-term loans on favorable terms that reward additional lending, we have succeeded in allowing banks to lower their lending rates, which has led to increased lending.

All of the measures we have taken in recent years have contributed to the economic recovery in the euro area making headway - albeit more slowly than expected and desired. As mentioned earlier, lending is increasing, as is demand. The unemployment rate in the euro area fell to 10.0% in the third quarter and the risk of deflation has decreased significantly. We expect the inflation rate to reach 1.6% in 2018, which is already very close to our target level.

However, in order to bring about a sustainable recovery, additional political support is required through structural reforms in various areas. Only in this way can we reverse the growth trend in the long term and increase the growth potential.

Even if the return to price stability is taking longer than originally expected and has become structurally more difficult, this does not yet constitute a reason to deviate from our goals - be it with regard to our definition of price stability or its parameters. A central bank has to be reliable, especially in times of greatest uncertainty. As Abraham Lincoln once said: You shouldn't change horses in the middle of the river.

Such demands have been made more frequently in recent times, especially in view of rising inflation rates. But growth is still hesitant and the inflation path is unsustainable, especially in view of domestic price pressures.

Against the background of this development, the question arises as to how much longer we can talk about even lower interest rates as an option. In view of the importance of credibility for a central bank, necessary adjustments to our actions and our rhetoric should not be delayed. At the same time, it is important not to rush anything. The fragility of recovery calls for a very cautious approach.

Low interest rates and accommodative policies remain appropriate in the current environment. The process of adapting to new circumstances takes time.

Monetary Policy Impact on Banks

Because we are aware that our measures are not free from side effects and that these become more apparent the longer these unconventional measures remain in use. It must be clear that these measures are of a temporary nature and by no means permanent part of our toolbox. But more on that later.

In order to contain possible risks as best we can, we are closely monitoring the further effects of our monetary policy. We pay particular attention to insurers, pension funds, but above all to banks, as these are central to the transmission of monetary policy.

Let's first take a look at the banks: ECB analyzes show that our measures have a positive overall effect on banks' profitability[1]. In the longer term, however, unusually low or negative interest rates together with a very flat yield curve and negative term premiums can have a negative effect[2].

Among the banks, those whose business is heavily dependent on maturity transformation and refinancing via deposits suffer particularly. And since it is difficult to pass on negative interest rates to private customers and the introduction of fees only provides limited relief, some banks will have to adapt their business models. Consolidation will also continue to be necessary in order to increase efficiency in the long term.

We can already see that concerns about the future profitability of banks are reflected in the performance of bank stocks. The index of banks in the euro area lost around 40% between August 2016 and August 2015. This decline was driven, among other things, by a clouding outlook for the global economy and growing concerns about the impact of the low interest rate environment and bad loans. As banks' stocks decline, their cost of equity increases, which in turn could reduce the net return on credit. This could lead banks to tend to be more conservative in lending in the future and raise lending costs. Internal calculations have shown that a bank stock drop by about 10% slows corporate lending by about 0.5 percentage points.

Together with other factors, such as the still high proportion of bad loans on bank balance sheets, as well as regulatory challenges, this could have a negative impact on the economic recovery in the euro area. We are therefore looking very closely at developments in this area.

What we have to avoid is that banks are artificially kept alive. Because in the long term this would only damage the economic recovery, as we have already seen in Japan. In addition, “palliative medicine for banks” is simply not part of the range of tasks of central banks.

Some institutes have failed since the financial and economic crisis. In Europe, we reacted to this, among other things with a comprehensive assessment of the banks for which the ECB took over supervision in 2014. The directive on the restructuring and resolution of credit institutions (BRRD) creates a uniform approach to failed banks in the EU, in which primarily the owners and creditors have to bear the losses - and not the taxpayers.

Banks that are in liquidation no longer benefit the real economy, they no longer grant new loans, no longer accept deposits and are only active to a limited extent in the money market. These institutions can no longer pass our monetary policy impulses on to companies and households. Accordingly, you shouldn't hang on to the central bank's drip, but rather refinance yourself in a different way.

The introduction of the BRRD and other rules is a huge step forward in making our financial system more stable. But we now have to apply these rules consistently and avoid exceptions as far as possible. Inconsistent application of the new rules to existing practices could expose the Eurosystem to unnecessary risks. Although ours closes General Documentation expressly stipulates that so-called Asset Management Vehicles (AMV), resulting from the splitting up of banks in the application of the BRRD, participate in the monetary policy operations of the ECB. However, this formal exclusion does not apply either to AMV subsidiaries or to AMVs that do not result from the application of the BRRD. The various technical bodies of the Eurosystem are currently investigating how the letter and spirit of our rules can be better reconciled.

Safe investment opportunities are becoming scarce

But the current low interest rate environment has not only exposed weaknesses among banks, it has also challenged traditional practices of insurers and pension funds.

The guaranteed interest rate has become the undoing of many insurers in Germany. It is becoming more and more difficult to achieve guaranteed interest rates of 4%, as was customary for new contracts in the mid-1990s, in the current market environment. The Federal Ministry of Finance has lowered the guaranteed interest rate for the coming year to 0.9% from 1.25%. Many insurance companies are now increasingly relying on unit-linked products.

In addition, new regulatory requirements are also driving up the demand for safe investment opportunities. German government bonds alone generate negative returns for up to eight years.

Against this background, it is discussed how this shortage of safe investment opportunities can be counteracted. One proposal, for example, provides for market participants to create a new type of safe asset, so-called European Safe Bonds[3]. These consist of the senior tranche of a portfolio of existing bonds from various countries in the euro area. The advantage would be that there would be no joint liability, as is the case with other proposals of this type.

It will be difficult to counteract an obvious assumption of public opinion that this is a communitisation of national debt through the back door. Especially since the approach of this model is very complex.

Such a new type of debt security could at best become an interim solution, on the way to a real fiscal union in the euro area, which would allow both common revenue and federal control of expenditure. Such a step would be the logical further development of European integration.

Increase potential growth

Let me conclude.

Today we took a closer look at the causes of our unconventional monetary policy. A worldwide weakening growth trend and a generally lower natural interest rate require low and even negative market interest rates in order to make investments and consumption more attractive. In the medium term, we want to bring the inflation rate back to a level that corresponds to our mandate of price stability of below but close to 2%.

Without our actions, the euro area economy would likely have slipped into another recession with increased risk of deflation. So we had to intervene and prevented worse from happening. Our analyzes show that the measures are having an impact. The euro area economy is recovering, albeit more slowly than expected. The risks of deflation have decreased significantly.

For the recovery to be sustainable, we must first and foremost address the causes of this global low interest rate environment. But monetary policy cannot do this on its own. In addition, our measures are not designed to be part of the system on a permanent basis. They have been used as temporary measures and must therefore be reduced again as soon as possible.

In view of the volume of the purchase programs, this will take some time, but continued use of our securities purchases, for example, would create disincentives for state financing - a development that could ultimately violate the ban on monetary state financing and would therefore not be compatible with our mandate.

The economic recovery cannot be carried out by monetary policy alone, but needs political support. Essentially, it is about reversing the trend in global growth. This includes making greater use of fiscal policy where there is space and need. Only then can our monetary policy return to normal. Above all, we also need reforms that, for example, ensure more flexibility in labor and product markets and increase productivity.

Because we have a mandate that says that we must achieve an inflation rate of below but close to 2% in the medium term. The longer it takes to achieve this goal, the greater the risk that the side effects of our measures will increase. While we are doing our best to keep the side effects under control, the financial industry must do its part and adapt to the new circumstances as far as possible.

It is important to avoid artificially keeping banks alive by giving institutions unjustified access to central bank refinancing operations. There is a need for clarification here.

At the end of the day, it is in all of our interests to do everything possible to return to sustainable growth as soon as possible. So let's not waste any time.