|
|
Speech by Yves Mersch, Member of the Executive Board of the ECB, Harvard University, 12 October 2016.
Interest rates on both sides of the Atlantic seem to be trapped near zero. At first glance, looking only at the short term policy rates, one might think that both the Federal Reserve (Fed) and European Central Bank (ECB) are facing very similar circumstances and challenges. Below the surface, however, the differences are pronounced.
In the euro area monetary policy continues to be highly accommodative, aiming to steer inflation back to levels in line with our definition of price stability. In the US, which is at a different stage of the business cycle, interest rate normalisation has so far been slower than expected
It is worth taking a closer look at the details to understand the unprecedented actions of central bank on either sides of the ocean in recent years.
To do so, it is useful to divide the crisis into three separate phases. The first phase was the global financial crisis after the collapse of Lehman Brothers just over eight years ago. Central banks worldwide faced a largely common challenge to avert a collapse in aggregate demand. The second phase centred on sovereign debt, a problem which only affected the euro area. In the third phase, which is still in place today, stubbornly low global inflation and anaemic growth are compounding domestic challenges.
The first phase: combating a systemic shock
The first phase of the crisis had its origin in the US. In 2006, many experts considered the subprime crisis to be a minor incident with only local impact, but then it escalated into a financial crisis of systemic proportions that propagated to the whole advanced world. Many banks experienced a sudden stop in their access to money markets, and the ensuing liquidity squeeze in interbank markets affected credit provision across the United States and euro area.
The effects on the real economy were immediate and large. Both regions went through severe recessions. But the respective central banks and fiscal authorities responded promptly and decisively.
The Federal Reserve quickly cut its target for the fed funds rate to close to zero, then embarked on a series of large-scale asset purchases of US government bonds and mortgage-backed securities. Likewise, the ECB cut its main refinancing rate by more than 300 basis points between October 2008 and May 2009. To ease the liquidity constraints of the banking system we altered the mode and maturity of our operations and widened the range of eligible collateral.
These responses were, in many ways, an extension of the existing operational frameworks. The asset side of the Fed’s balance sheet traditionally consisted mainly of holdings of US government bonds. By contrast, the ECB, lacking a single fiscal counterpart, injected liquidity mainly through repos with banks. This mode of operation reflected in turn the predominance of bank-based intermediation in the euro area.
Coupled with a sizeable fiscal impulse, both types of actions were successful in delivering the stimulus needed to counteract the shortfall in aggregate demand, stabilise output and initiate the economic recovery. Unemployment in both jurisdictions, which had spiked in the early phase of the crisis, levelled off and began to decrease.
[...]
The second phase: unique institutional challenges
The ECB responded to the sovereign debt crisis with various new monetary policy measures, such as our long-term lending operations, and even began purchasing sovereign bonds under the Securities Markets Programme. All these measures aimed to support bank funding markets and ensure that the flow and pricing of credit to the real economy was in accordance with our intended monetary policy stance.
But a question often asked is why we did not resort to large-scale asset purchases at this point, as the Fed was already doing. Bear in mind that inflation developments in the euro area at the time did not suggest a tight stance. Headline inflation was rising steeply from its 2009 trough, exceeding 3% in October 2011, partly driven by an increase in underlying inflation. Inflation expectations were well anchored around our objective.
Hence our diagnosis of the problem in this period focused more on monetarytransmission than on the policy stance. Our stance was not being transmitted evenly across all parts of the euro area. And so our measures in this period were specifically designed to remove those impairments in transmission.
The main issue we faced was the perverse interaction between the euro area banking sector and institutional incompleteness of our monetary union, which had fundamental implications for our policy in a system of bank-based monetary transmission. While the first phase of the crisis can be interpreted as a severe recession amenable to monetary policy, this second phase was the consequence of institutional challenges that monetary policy could only aim to mitigate, but could not overcome.
Despite swift efforts to set up a European Banking Union there were in fact three major differences between the euro area and US in terms of the environment facing monetary policy: the sluggish recovery of the banking sector, the fragmented fiscal framework of the euro area and the structural rigidity present in many euro area economies.
The necessary process of banking sector repair proceeded much more slowly in the euro area than in the US. Indeed, here in the US it was more or less completed by end-2011, but in some euro area countries it is still ongoing, even today. US authorities exerted pressure on banks (and non-financial corporations) to recapitalise with public money, via the Troubled Asset Relief Program. In the euro area, there was a preference for recapitalisation through organic growth.
Recapitalisation in the United States was bolstered by the early and effective use of stress tests in the US to restore confidence in solvent banks, reinforced by a credible backstop. By contrast, early attempts at stress tests in the euro area were hampered by splits among national supervisors and, with only national backstops available, the tests proved unsuccessful at restoring confidence in the banking system. US banks were also encouraged to recognise non-performing loans (NPLs) more quickly, freeing up capital for new lending.
The third difference was the ability to efficiently resolve insolvent banks and prevent the emergence of “zombie lenders”. The US had a trusted process through the Federal Deposit Insurance Corporation, backed by a credit line from the US Treasury. By contrast, prior to the crisis many member states of the euro area did not even have a national resolution framework. Since 2008, the FDIC has resolved over 500, mostly smaller banks in the United States. While determining the exact definition is tricky in the euro area, the number appears less than a hundred.
All this explains why the recovery of the banking sector took longer in the euro area, which our monetary policy had to work to mitigate. And what is more, when public authorities in the euro area did intervene to backstop their national banking sectors, the fiscal implications naturally differed: the onus fell entirely on national budgets. This in turn contributed to the second area where the euro area and the US diverged: the emergence of the so-called “vicious loop” between banks and sovereigns, which further delayed the financial repair process.
[...]
European institutions need to be strengthened in other areas, too, notably those governing fiscal policies. To my mind this must entail moving from a framework of decentralised rules to more effective central institutions; it hardly helps credibility when we take years drafting new rules only to break them at the first test. And there is still an urgent need for more structural reforms – because third phase of the crisis has been, above all, structural.
The third phase: the re-emergence of structural challenges
This third phase – which we are still in today – has been characterised by two main challenges: low inflation and low growth. Just as in the initial phase of the crisis, these are common challenges for advanced economy central banks. But what has become increasingly clear is that the challenges today have a much stronger structural element. Low global inflation is partly a cyclical phenomenon – linked to falling energy prices and the slowdown in major emerging market economies – but it is also a result of structural changes brought about by globalisation. And the secular slowdown of global growth has brought with it declining long-term interest rates across the advanced world.
To be sure, the intensity of these challenges has varied across jurisdictions. The euro area, still recovering from its double dip recession, has faced a more prolonged period of low core and headline inflation, which the ECB has reacted to by launching three new unconventional tools: a set of targeted long-term refinancing operations with in-built incentives for banks to lend, a negative interest rate policy, and an asset purchase programme encompassing public and private sector securities. These measures aim both to smooth transmission and to expand the policy stance to combat excessive disinflationary pressures. And they have been effective in easing financial conditions and supporting the recovery.
Yet it is clear that, for all central banks, the structural backdrop has made monetary policy normalisation slower. Consider lower growth. It is now clear that the long-run growth potential of major economies has been falling for a number of years. For example, the Consensus forecasts for long-run growth real GDP for the US – that is the average growth six to ten years – stood at 3.1% in early 2003. The latest figure is just 2.2%. Long-run growth forecasts for the euro area were revised down from 2.2% to 1.4% over the same period. These lower forecasts represent in part the impact of ageing populations, but also reflect the falling trend in total factor productivity.[4]
This affects monetary policy because slower growth in potential output reduces what is often referred to as the equilibrium interest rate.[5] While not directly observable in the real world, this widely used concept is organised around the notion of an equilibrium level of the rate of interest where there is neither upward nor downward pressure on inflation. If the equilibrium rate falls, the margin above the effective lower bound becomes compressed, reducing the space in which central banks can operate to provide accommodative policy.
One might reasonably ask why central banks did not identify this trend sooner. The answer seems to lie in an overreliance on pro-cyclical estimates of potential output. Indeed, the revisions to estimates of potential growth have mostly occurred after the crisis, whereas it is most likely that the slowdown in productivity had already startedbefore the crisis but was masked by the credit-fuelled boom. For example, in 2007 the euro area’s output gap was estimated by international institutions such as the IMF, the OECD and the European Commission to be negative – somewhere between -0.2% and -0.6%. The most recent estimates put the output gap in the region of positive 2.7% to 3.4%, a significant downward revision to views of potential.
[...]
Conclusion
Roughly eight years of extremely accommodative monetary policies on both sides of the Atlantic might lead to the notion that the ECB and Fed have been confronted with similar or even homogenous challenges. This would be a misapprehension.
Major institutional and structural differences at the onset of the financial crisis explain why the clean-up efforts in the US were faster and more effective and the recovery was more sustainable.
After the institutional short-comings of Monetary Union had been painfully exposed, much progress has been achieved on the road to completion and further integration. However, this institutional reform package took time. Now, economic recovery, although still timid, is under way in the euro area.
But this finding cannot be taken as an excuse to rest on our laurels. More determined structural reforms need to be implemented to lift the growth potential and overcome the ultra-low interest rate phase. A more determined approach to tackle the problem of non-performing loans is necessary to tackle the remaining legacy of banking crisis.
When the macroeconomic ship is engulfed by a major storm, all hands – not just monetary policy – need to man the pumps. This, indeed, holds true on both sides of the ocean.