10 September 2015

ECB: The low interest rate environment in the euro area

ECB's Praet focused in his remarks on the question: what are the conditions that will allow for rates to rise back to levels that, looking retrospectively, are considered “more normal”?

Keynote speech by Peter Praet, Member of the Executive Board of the ECB, at a Pension Funds Conference organised by De Nederlandsche Bank in Bussum, The Netherlands, 10 September 2015

[...] My answer can be summarised as follows. Very low interest rates are not so much a choice of the central bank as a reflection of economic malaise in the global and euro area economy. Some of the drivers of that malaise are secular, which are more challenging for public policy to affect. But others are related to demand conditions that appear weak even when compared with a long-term potential growth rate that is already disappointingly low.

Such persistent economic slack relative to potential can be reversed through targeted measures. That includes tackling the cyclical headwinds that are dragging on aggregate demand; facilitating the process of balance sheet repair; and removing the structural barriers to higher real growth prospects, which can itself reinvigorate demand through expectation and confidence channels.

The role of monetary policy is mainly to provide countercyclical stabilisation while the economy goes through this transition. When the economy is weak, after all, disinflationary pressures increase, which we have to counter to deliver on our mandate. The monetary policy measures currently in place in the euro area follow from this: they were decided as a direct result of a euro area inflation rate well below comfortable levels and persistent weakness in the economy. And in meeting our objective, we support growth and inflation, which in turn creates the conditions for interest rates to “normalise” once more. Of course, the level that rates will return to in the future is dependent upon the degree to which the secular drivers, currently depressing rates, can be reversed.

Challenges of the low interest rate environment

Let me start, however, by briefly touching on the challenges the current situation poses for the pension fund sector, as well as for the insurance sector given its similar focus on fixed income assets and the prevalence of long-term liabilities. Large euro area insurers show quite reasonable profitability, albeit the aggregate picture masks substantial heterogeneity across countries and types of business. Small and medium-sized, non-diversified life insurers with high policyholder guarantees are typically highly exposed to low yields and have found their business models more under pressure. For pension funds the impact of low interest rates is strongest on those maintaining defined benefit schemes. [...]

Understanding low interest rates

[...] it is important to understand why interest rates are so low. And a closer examination reveals that the underlying drivers are not so much central bank policies as global and euro area-specific economic factors, some of which are more secular in nature and others which are more associated with the legacy of the post-Lehman financial crisis.

To comprehend this point, it is useful to decompose long-term nominal yields into four components: expected inflation over the term of the asset; the expected path of short-term real rates; the inflation risk premium and real term premium, which together represent the compensation required by investors for holding long-term bonds as opposed to rolling over short-term securities. All these components have contributed to the very low long-term rates we observe today. [...]

The role of monetary policy

Monetary policy has certainly contributed to reducing interest rates. Yet our policy should be understood as a response to this challenging context. Monetary policy cannot affect the secular forces weighing on the euro area economy, nor can it provide an answer to our institutional and structural questions. What it can and must do, however, is respond to the weakness in aggregate demand and the disinflationary pressures that creates. [...]

To sum up, low interest rates are ultimately a consequence of weak secular trends, coupled with the cyclical consequences of a complex debt crisis, exacerbated by a monetary union with institutional and structural flaws. “Normalisation” is therefore not about the central bank raising policy rates or removing the accommodation provided through its unconventional policy measures – this would only result in too tight a monetary policy stance and make the situation worse – it is about addressing each of these underlying drivers that are holding real rates and inflation expectations down.

Addressing structural and institutional challenges

[...] If monetary policy is to have its full effects on the economic cycle, it needs to be supported by policies that help dislodge negative sentiment about the euro area’s prospects and induce higher investment. [...]

In my view addressing this situation has three parts.

The first is boosting the euro area’s long-term growth prospects, which given our demographics comes down chiefly to raising TFP. [...]

The second part is accelerating the process of private sector debt workout within the euro area. [...]The Capital Markets Union project could be an important catalyst here as it should ultimately induce convergence in both these areas.

The third part is addressing the institutional incompleteness of our monetary union. There are several dimensions to this, as laid out in the recent Five Presidents’ Report, but a priority is completing Banking Union and the integration of the euro area banking sector. [...]

Progress on these three fronts would not only go a long way towards removing the factors preventing higher and sustainable growth. It would also accelerate the normalisation of interest rates away from low levels.

Conclusion

What I have tried to explain today is that the central bank policies should not be interpreted as a cause of low interest rates but rather as a consequence of economic malaise and disinflationary pressures, which the central bank aims to forestall. That is to say, they are simply the mirror image of global and euro area specific factors that are pulling both long-term nominal and real interest rates down to very low levels. Addressing those factors with determination can accelerate the process of “normalisation”.

That implies on our side the full implementation of the asset purchase programme, on which the cyclical recovery hinges. And it implies on the side of other policymakers addressing the structural and institutional factors that are preventing our monetary policy from producing a stronger and more sustained recovery. In other words, a lasting return to normalcy depends on all policymakers playing their part – and the longer others wait, the greater the hurdles that the euro area will ultimately have to climb.

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