10 December 2013

ECB/Draghi: Money and monetary institutions after the crisis

Draghi said central banks should focus on what they are mandated to achieve, which is price stability over the medium term. He also stressed that the actions undertaken by the ECB did not represent a departure from the ECB's mandate. (Includes comments from EP hearing on the ECB's Annual Report)

The ECB’s monetary policy strategy with its medium-term orientation and emphasis on monetary analysis explicitly involves looking beyond short-term price developments and taking into account the medium-term implications of booming asset prices and credit markets for price stability.

The answer to the question how actively monetary policy should be used to "lean against the wind" will depend on the answer to two other questions:

1. How effective will the new macro-prudential policy framework be in reining in the financial cycle and maintaining financial stability?
2. What is the effect of monetary policy on risk taking and financial stability?

Regarding the first question on the effectiveness of macro-prudential policies, the experience with those policies as a stabilisation tool is relatively scarce and often confined to emerging market economies. In the euro area, the Spanish experience with dynamic provisioning shows that increasing buffers during the credit boom can increase the resilience of banks. However, at the same time it did not prevent the large run-up in credit and real estate prices and its subsequent painful and protracted bust, suggesting that a more intrusive macro-prudential policy may be necessary. I trust that the new macro-prudential tools created under the Capital Requirements Directive IV, combined with the new role of the Single Supervisory Mechanism in macro-prudential decision-making, will help provide that intrusiveness.

Regarding the second question, there is by now considerable research on the effect of monetary policy on risk taking in the financial sector (also by ECB researchers), but the quantitative importance and hence policy relevance of this channel is still unclear and subject to a lot of debate. It is also unclear whether monetary policy can have an influence on financial stability that would be predictable and systematic enough to allow it to be exploited.

There are additional elements to be considered when conducting monetary and macro-prudential policy in a still heterogeneous economy such as the euro area. Dealing with the financial cycle from a purely national perspective can be detrimental to financial integration, but the common monetary policy cannot fully deal with a financial cycle that is not synchronous across countries. In sum, there are many uncertainties associated with the ability of both monetary and macro-prudential policies to rein in the financial cycle.  

We need to continue and further strengthen the financial sector reform agenda and build more resilience in the financial system. While our knowledge to fine-tune the financial cycle may be limited, the financial system must be made more robust to shocks by, for example, increasing capital and liquidity buffers. The creation of a Banking Union and the comprehensive assessment leading up to it are essential steps in improving the governance of the financial sector in the euro area and increasing its resilience.

Trust in central banks

Trust is important not only as an end in itself, but also because it contributes to economic efficiency. This view stipulates that the ultimate objective of institutions such as central banks is to reduce transaction costs. A high degree of trust by citizens is ultimately the most important safeguard of central bank independence in the long term. Legal provisions for central bank independence are important, but not as important as public trust over the long term. 

On the one hand delivering their mandate is the only way for central bankers to maintain public trust; on the other, their pursuit of their mandate must be backed indirectly by public preferences, seen from a longer term perspective. I would be the first to acknowledge that there can be a tension between these two dimensions in the short run, and that delivering price stability has been more challenging in recent years, in part due to financial fragmentation in the euro area. The ECB has been addressing financial fragmentation in the euro area since its beginning in 2011. This effort has included the provision of liquidity to the banking system in abundant and uniform terms across the whole euro area, against good quality collateral and subject to risk management limits; as well as securities market purchases, the Securities Market Programme and the covered bonds purchase programme, and the Outright Monetary Transactions (OMT) programme.

I would like to emphasise that these efforts do not represent a departure from the ECB’s mandate, but rather the opposite – namely, the pursuit of price stability by all the necessary means that the situation has required. In short, the ECB has preserved price stability and the necessary conditions for sustainable growth, fought redenomination risks and the fragmentation of financial markets. Time has been gained for other actors to contribute their part in crucial policy domains that do not belong to the competence of ECB as defined by its mandate. The European reform agenda has been put on a new footing.  It is now crucial to complete this agenda at the European and national level.

Full speech

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In a hearing at the European Parliament on 12 December, Draghi reviewed the ECB's more recent monetary policy decisions and addressed institutional matters of particular interest to the EP as well as the progress made so far in reinforcing EMU governance. 

Progress made towards a genuine EMU

The establishment of the Single Supervisory Mechanism (SSM) represents probably the most significant change to the EU since the establishment of the single currency and I am happy to report the internal preparations are well underway. I strongly welcome the political agreement on the Bank Recovery and Resolution Directive you have reached with the Council yesterday night.  Swift agreement on the other key component of Banking Union - the Single Resolution Mechanism - is of paramount importance. Looking ahead we will have a stronger set of rules for capital and liquidity. We will also have a new toolbox for the resolution of financial institutions. And we will have stronger national deposit guarantee schemes.

Banking Union however is not a panacea for eliminating financial market fragmentation and fully stabilising EMU. It is a necessary, but not sufficient condition to break the bank-sovereign nexus and restore sustainable economic growth. Equal borrowing conditions can only be ensured through the joint implementation of other measures. This not only includes continued fiscal consolidation and implementation of structural reforms, but also progress on the other ‘unions’. Only then can we say we have created a genuine EMU. Let us seize the opportunity of the next EP elections to have an open public debate on the further steps needed to strengthen the architecture of EMU.

Full speech

Plenary Session: European Central Bank: "Independence without democratic scrutiny is dangerous", 12.12.13

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