Prospects for monetary policy implementation
Speech at the 2018 Banking Evening at the Deutsche Bundesbank’s Regional Office in Baden-Württemberg
- 1 Introduction
- 2 A look in the rear view mirror: the changing world of monetary policy implementation
- 3 The implementation of monetary policy today
- 4 Outlook: is a normalisation of monetary policy in sight?
- 5 Conclusion
Ladies and gentlemen
Many thanks for inviting me to speak at this year’s Banking Evening at the Regional Office in Baden-Württemberg.
Economic conditions in Germany are exceptionally upbeat right now, and that is due, in no small part, to Baden-Württemberg, which ranks as one of the country’s foremost business regions. The impressive state of the Baden-Württemberg economy is also the subject of the last economic report published by the region’s Chamber of Commerce and Industry in October 2017, which discusses how the south-west economy is going from strength to strength. It also notes that confidence levels in Baden-Württemberg are as robust as ever, largely on the back of a steady upturn in domestic and foreign demand. That is particularly the case in the region’s key business sectors in manufacturing industry.
That upbeat underlying sentiment is also having a knock-on effect in the financial sector, where the banking statistics figures for Baden-Württemberg have been pointing to a trend increase in lending to non-banks including enterprises for some time now. Indeed, the third quarter of 2017 saw the supply of credit to all non-banks climb by 3.5% year on year, and lending to enterprises grow by 7.7%.
Speaking as a central banker, that’s music to my ears. After all, it means that the banking industry representatives among us this evening are facing up to the challenges that lie ahead with confidence. I don’t need to tell you that the challenges of the future also include digitalisation and monetary policy, which are both topics which concern me in my capacity as the Bundesbank Executive Board member responsible for IT and markets.
IT is a topic I would like to leave aside this evening, even if it does account for a great deal of my day-to-day work, and no doubt yours, too. I would like to say, though, that buzzwords like cyber security, FinTech, distributed ledger technology and cryptocurrencies are informing the digitalisation debate. But at this current juncture, it’s difficult to gauge just how much of an impact digitalisation is going to have on the financial sector. There are many who regard digitalisation as a source of transformative or even disruptive potential – not just in the financial sector but no less so in the real economy as well. Politicians have acknowledged the importance of digitalisation.
Turning to market matters, which are my second area of responsibility, this is a topic that mainly concerns monetary policy, or to be more precise, its implementation. And as a central banker, it’s also a topic that brings me face to face with you, the banking industry representatives. Because it’s your institutions that play a crucial role in channelling monetary policy stimulus to the real economy.
The speech I intend to deliver at today’s Banking Evening will explore the state of play in the field of monetary policy. I shall begin by looking back at the monetary policy path that got us where we are today, before turning my attention to today’s monetary policy and its implementation, singling out the monetary policy asset purchase programmes which have been running at a reduced monthly pace since January 2018. My speech will conclude with a look ahead at the future of monetary policy implementation in a financial universe that has undergone structural change.
2 A look in the rear view mirror: the changing world of monetary policy implementation
Let’s kick off, then, by briefly looking at past monetary policy. In the early years, the Eurosystem conducted its interest rate policy by the book, allotting just enough central bank money, in a structural liquidity deficit, to cover the aggregate banking sector’s calculated liquidity needs. Banks then turned to the money market to balance their liquidity positions. Eonia, the unsecured overnight money market rate, usually hovered not far from the Eurosystem’s policy rate for its main refinancing operations. One welcome side effect of classic interest rate policy, with its calculated allotment of central bank money, was that it kept the central bank’s balance sheet lean. It did not become any larger than strictly necessary.
During the global financial crisis and the sovereign debt crisis in the euro area, the Eurosystem realised that classic interest rate policy alone was not fit for purpose. The ECB Governing Council acknowledged that asset markets were malfunctioning and also found that the monetary policy transmission mechanism had been disrupted. It therefore decided to roll out non-standard measures to support the monetary policy transmission process. These non-standard measures included long-term credit operations with full allotment as well as outright purchases of certain assets, to complement the central bank money provided by the Eurosystem in the shape of short-term revolving facilities. Later on, the monetary policy reins were loosened further because the majority of ECB Governing Council members saw a risk of deflation – a dangerous downward spiral of sinking prices and wages. But by embracing these exceptional measures, European monetary policymakers ventured deep into uncharted territory. These measures caused the Eurosystem’s total assets to double from roughly €2.2 trillion at the beginning of 2015 to the current level of around €4.5 trillion, and sent excess liquidity in the banking system up to around €1.9 trillion at last count. In this setting, the anchor for the monetary market rate slid down the interest rate corridor to the deposit facility rate.
All things considered, Eurosystem monetary policy has experienced a paradigm shift over the past decade. The move away from a lean balance sheet, especially, is fraught with a number of risks. But I’ll come back to that later.
3 The implementation of monetary policy today
Ultra-loose monetary policy is still the name of the game today, and that’s due, in part, to a quintet of non-standard monetary policy measures. First, the very low, and in some cases, even negative monetary policy rates; second, a fixed-rate full allotment procedure to cover whatever liquidity needs banks have (provided they have sufficient eligible collateral); third, the still-outstanding targeted longer-term refinancing operations with an original maturity of up to four years; fourth, the purchase programmes for various asset classes; and fifth, the forward guidance which the ECB Governing Council uses to map out the likely future path of monetary policy from today’s perspective.
The still-operational and widely debated asset purchase programme, or APP, is one of the main pillars supporting the highly accommodative monetary policy. To date, the Eurosystem has used the APP to purchase something like €2.3 trillion in assets. The idea behind this quantitative easing is to loosen financing conditions in the economy as a whole to such an extent that it will ultimately be possible to achieve the price stability objective, which is an increase in the Harmonised Index of Consumer Prices of "below, but close to, 2% over the medium term".
As part of the APP, the Eurosystem is purchasing government bonds (public sector purchase programme, or PSPP), covered bonds (the third covered bond purchase programme, or CBPP3), securitised assets (asset-backed securities purchase programme, or ABSPP) and corporate bonds (corporate sector purchase programme, or CSPP). The ECB Governing Council decided in October 2017 to halve the monthly net asset purchases under the APP from €60 billion to €30 billion, starting in January 2018, and also to continue the purchases at least until September 2018.
From an operational vantage point, our job is to smoothly put the Governing Council’s monetary policy decisions into practice. In terms of the APP, this means not only acquiring the monthly purchase volume announced but also, as far as operationally possible, minimising the negative side effects on market functioning. In my view, the Eurosystem has succeeding in carrying out the purchases with as little impact on the markets as possible. At least we did not notice any material tension during our purchases.
To those who occasionally voice fears that Federal bonds might be running short, let me use my speech here today to reiterate my reassurances that the Bundesbank sees no operational hurdles whatsoever that might prevent it from purchasing assets under the PSPP as scheduled until the end of the programme and in line with the ECB Governing Council’s instructions.
The Eurosystem’s open and transparent communication aided the implementation of the purchases, judging by the fact that the markets pretty much took the Governing Council’s decision in October 2017 to reduce the pace of asset purchases from January 2018 in their stride.
The yield hike in Federal bonds since mid-December started from quite low levels and mirrors an upturn in US Treasury yields. The markets see German and US government paper as interchangeable given their status as safe assets. That’s why their yields often follow similar patterns over the long term, even if they have long been hovering at different levels due to differences in the monetary policy backdrop on both sides of the Atlantic.
The recently published figures for January 2018, the first month at the reduced pace of €30 billion, indicate a relative shift between the individual programmes making up the APP. The "small" programmes – CBPP3, CSPP and ABSPP – now account for a much larger share of the overall purchases, with the purchases of corporate bonds under the CSPP, especially, assuming a relatively strong weight, at around €6 billion. However, this is partly the result of seasonal factors. New issues of corporate bonds are not spread evenly across the year but are typically clustered at the beginning of the year, and this is one of the main reasons why the CSPP made up a relatively large proportion of purchases under the APP. Compared with the average figures for the previous months, the weight of the three "small" programmes roughly doubled overall in January 2018.
Notwithstanding this recent relative shift, the PSPP for government bond purchases is still by far the largest purchase programme under the APP. I won’t be telling you anything new when I say that the Bundesbank regards government bond purchases by Eurosystem central banks as an instrument that should only be used as a last resort. The purchases of government paper have transformed central banks into the member states’ largest creditors. They are making the boundary between monetary policy and fiscal policy increasingly blurred. Governments’ financing conditions are now far more reliant on the actions of central banks than they once were. This creates a proximity between fiscal and monetary policy which could evolve into a threat to the Eurosystem’s independence.
The ECB Governing Council laid down stricter rules for purchases of government bonds under the PSPP than for the other programmes making up the APP, and for good reason. Thus, Eurosystem holdings may not exceed 33% per security and 33% of a country’s overall outstanding volume of bonds. Furthermore, the national central banks (NCBs) which make up the Eurosystem only purchase government bonds issued by their own country, and any losses resulting from purchases carried out by NCBs are not shared across the Eurosystem. That is why the government bond purchases by NCBs follow the ECB capital key, which takes into account each country’s gross domestic product (GDP) and population size. Gearing purchase operations to the capital key prevents too many bonds from being purchased from individual countries. Any change to this parameter would gravitate monetary policymakers deep into the realm of fiscal policy, which would put a central bank’s credibility and reputation at stake.
I therefore welcome efforts by the general public to monitor compliance with the rules. Unfortunately, however, this sometimes leads to misunderstandings. There were reports in some media, for instance, that the Eurosystem was deviating from the capital key for political reasons. These reports were backed up with figures alleging that the percentage shares of the assets purchased from some individual member states were larger than they were permitted to be according to the capital key.
However, the fact is that the country allocation for purchases under the PSPP is governed by a clear set of rules and is based on the capital key. There is no provision for discretionary scope for politically motivated deviations, such as to support specific countries. The key reference indicator, however, is the entire stock of public sector bonds purchased under the PSPP, not net sales in individual months. If we only look at certain purchase periods, misinterpretations can be the result. Chronological, quantitatively restricted deviations from the capital key are possible, for a variety of reasons. This is not a new phenomenon, however, but due to technical reasons which, in some cases, overlap.
One of these reasons lies in what are known as replacement purchases. Countries for which an insufficient quantity of public sector bonds is available or whose bonds are not permitted to be purchased can, as a substitute, purchase bonds issued by supranational institutions. This causes a reduction in their share and is lower than according to the capital key. Because of the rule stipulating that the breakdown between public sector bonds and bonds issued by supranational institutions must remain unchanged (at 90% to 10%), the relative share of countries that do not need to conduct replacement purchases of supranational bonds, such as France and Italy, automatically increases. However, for this reason, the share of German bonds in the entire PSPP stock is likewise (somewhat) higher than the capital key. For member states conducting replacement purchases, the share is accordingly smaller than their nominal capital key share.
Another reason is that purchases should remain market-neutral wherever possible. The Eurosystem is at pains not to impair the functioning of the markets and price formation. The specific design of the asset purchase programmes therefore gives the Eurosystem the wherewithal to respond flexibly to sudden swings in liquidity in the bond markets or of individual bonds, such as bringing forward purchases or spreading them out over time. This occurs regularly in the months of August and December – months characterised by low levels of market liquidity. Major maturities in our bond portfolios which we have to reinvest are a second example. In order to conserve market liquidity, we can stretch such reinvestments over a period of up to three months. This then necessarily leads to corresponding deviations in individual months, which, however, right themselves in the following months. Yet another way in which the Eurosystem strives to improve market liquidity is by decentrally making available the purchased assets for securities lending.
4 Outlook: is a normalisation of monetary policy in sight?
The highly accommodative monetary policy stance of the Eurosystem has contributed to the economic upswing. The euro area economy is seeing sustained and broad based growth, albeit with differences from one region to the next. Indicators of economic activity and sentiment are pointing to a continuation of the robust and increasingly self-sustaining economic upswing. The euro area labour market is continuing to recover. The unemployment rate, at 8.7%, has returned to the level it stood at between the launch of the euro and the outbreak of the crisis; employment is growing strongly.
The Governing Council of the ECB, however, is basing its monetary policy not on economic developments but on the objective of price stability. And consumer price movements in the euro area are still muted. According to ECB staff projections, the inflation rate will be 1.4% in 2018, 1.5% in 2019 and 1.7% in 2020. An expansionary monetary policy stance is fundamentally appropriate in this setting for now. However, the forecasts are pointing upwards and, in my view, consistent with a path towards the medium-term target inflation rate of below, but close to, 2%.
The Governing Council of the ECB is therefore currently debating how accommodative monetary policy should be and what instruments should be deployed.
You're right to say this: the ongoing low-interest-rate period is unquestionably a particularly great challenge for your banks. As a former member of the board of the Association of Sparda Banks, I fully empathise with your concerns about deposit and lending business, which are dependent on interest rates. And I am also well aware of the squeeze on savers, who are receiving next to no interest income on risk-free investments.
For all the scepticism, there is also another side to the story. Many are benefiting from the favourable funding conditions: banks, via lower customer default rates; firms, in their investment projects; and everyone in the country via, for instance, an improved labour market. Moreover, low interest rates are giving the public sector fiscal space. Central, regional and local government combined have saved nearly €300 billion on interest since 2008.
All these factors combined have helped to create an enormously positive macroeconomic environment. And this environment together with upward domestic price pressures have opened a window of opportunity for a normalisation of monetary policy.
Moreover: the longer an accommodative monetary policy is maintained, the more its impact is likely to dissipate, while the risk of undesired side effects increases. The degree of monetary policy accommodation has already been priced in by the markets, and the habituation effect is reflected in low volatility. Above all, however, there is the question of the latitude for monetary policy action once the next downturn sets in.
In addition, the Governing Council of the ECB has always pointed out that the non-standard monetary policy measures cannot, in the long term, resolve the underlying causes of the crisis. For that to happen, national governments in the euro area will need to initiate reforms and structural adjustments.
But even after discontinuation of net asset purchases, monetary policy would remain accommodative. After all, the deciding factor is not so much the amount of monthly purchases – the "flow" – but, above all, the total volume of bonds – the "stock" – on our balance sheet. Through reinvestment, the stock of bonds on the balance sheet will remain at a very high level, since maturing bonds will be replaced by purchases of new bonds. In addition, the ECB Governing Council, as part of its forward guidance, has announced that it would not increase interest rates until net asset purchases have been discontinued.
However, monetary policy normalisation is not just about finding the right time and sequence for scaling back the crisis-related non-standard measures. It is also about how monetary policy responds to lasting change in the financial markets.
In the past ten years, the financial markets have seen a raft of changes in response to the financial and sovereign debt crisis. Such structural change affects how monetary policy is implemented. Let me highlight two examples of changes that have characterised, and will continue to characterise, the money market.
One is that infrastructures are continuing to evolve – not least owing to technological change. This includes, for instance, payment and securities settlement systems such as those being used by the Eurosystem. Their properties and operational efficiency impact on the money market. They affect money market actors’ propensity to hold central bank reserves with the Eurosystem as well as the manner in which they optimise their reserve holdings. The effectiveness of the implementation of monetary policy thus also depends on how money market players use financial market infrastructures.
The other is that supervisory capital and liquidity rules have been reworked at the global and European levels. In order to comply with the new liquidity rules, ie the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), banks take measures which have a major impact on trading in the money market. Banking regulation is the subject of particular attention right now. Although banks, even during the crisis, were tending to hold much more liquidity and also to secure their money market transactions, both trends – higher liquidity holding and the securing of transactions – have been amplified by the recent regulatory reforms. Regulatory scarcity of liquidity or collateral could impair the monetary transmission process in the short term, because such scarcity impacts on interest rates in the money market – which could then become decoupled from the thrust of monetary policy. It is therefore in the interest of the Eurosystem to keep an eye on the interaction between regulation and monetary policy implementation from a monetary policy perspective.
In the long term, however, there are further structural changes, of which I will only name a few – reforms of benchmark interest rates and the increased use of central counterparties, consolidation in the banking industry, and the influence of digitalisation combined with the advent of non-bank service providers (fintechs). Such changes likewise need to be taken into account when implementing monetary policy in years to come. There is an added challenge: massive excess liquidity. What money market management model should the Eurosystem pursue going forward? Will there be a gradual return to money market management given a structural liquidity deficit in the banking system? Or will there be a new money market management model in a situation of excess liquidity? It is too early for an answer just yet, but it is never too early to tackle challenges confidently.
Ladies and gentlemen
Over a century ago, the German philosopher Wilhelm Dilthey (19 November 1833 in Biebrich, Nassau – 1 October 1911 in Seis am Schlern, Austria-Hungary) provided a timeless template which summarises the speech I have delivered today. He wrote the following bonmot:
"And thus the present is pervaded by the past and bears the seeds of tomorrow."
What this means for European monetary policy is: the crisis was yesterday, growth is today, and it is therefore time to take this into account in our monetary policy stance. We want to switch off crisis mode and take the new challenges into our sights. That would also be in the best interests of banks here in the south-west.
- Source: Regional banking statistics figures for Baden-Württemberg.