International Monetary Fund, Deputy Director, European Department
Lorenzo Bini Smaghi
Société Générale, Chairman
Oesterreichische Nationalbank, Governor
Luiz Awazu Pereira da Silva
Bank for International Settlements, Deputy General Manager
1. The accommodative monetary policy of the Eurosystem: effects and side effects
The ECB has engaged in a very bold expansionary monetary policy, particularly since the beginning of 2015. The Chair asked what the current balance of the positives and negatives is as regards the ‘ultra-accommodative’ monetary policy of the ECB.
A central banker replied that the positive aspects are much bigger than the side effects. The ECB is currently providing €2,500 billion of central bank liquidity, about two-thirds of which is generated through the extended Asset Purchase Programme (APP). From April 2017, net asset purchases are intended to continue at a monthly pace of €60 billion until the end of December 2017 or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. This is a very intensive operation but it has been successful.
1.1. Non-standard measures support GDP growth
A central banker stated that GDP is growing. There are even upward revisions in the forecasts now, and this is very important. The danger of deflation no longer exists, so this is an area where monetary policy measures have been successful. The situation is that unemployment has started to decline. This is a number that is not well known in Europe: since 2013, four million new jobs have been created in Europe. This is something of which there should be awareness. The recovery in investment also continues to benefit from very favourable financing conditions. There have been positive effects. Of course, this is not only due to monetary policy, because it is known that monetary policy cannot be the ‘only game in town’. There have been certain structural reforms, and it would be wrong to say that nothing has been done. There are also worldwide, positive developments in the world economy. The signs of a stronger global recovery and increasing global trade suggest that foreign demand should increasingly add to the overall resilience of the economic expansion in the euro area. Taking everything together, however, this has proved to be a success.
The central banker argued that the background paper prepared by Eurofi for this discussion concentrates more or less only on the negative perspectives. Of course, a long period of ultra-low interest rates implies risks: for instance, low interest rates may induce households and businesses to invest in riskier assets. Low interest rates are also challenging for banks and insurance companies, as their profitability might suffer. As monetary policy makers, the members of the ECB Governing Council are concerned about these risks and monitor them closely. However, the central banker wanted to balance the picture.
An official stated that the important role that central banks have played during the global financial crisis should be recognised. Central banks saved the world from another Great Depression, and this has to be noted and commended. The positive aspects are beginning to be realised now, although they have been somewhat slow to appear. Ben Bernanke had stated that the problem with QE is that it works in practice but it does not work in theory; it is working now in practice. Vítor Constâncio had just reminded this audience of some good growth indicators. There are also some collateral effects when too much of this ‘strong medicine’ is used for too long, in terms of the financial health of the industry.
1.2. The downside of the current situation is the negative rates
A banker stated that the downside of the current situation is the negative rates. Over time, it will increasingly hurt bank profitability and thus the credit channel. The problem is how to get out from negative rates, given that, to some extent, Europe got into a situation of negative rates in the hope of not getting into QE, and both negative rates and QE occurred. The question in the current environment is due to the uncertainty about when and how to exit. At some stage, the discussion will arise in debate and in the newspapers, and that is what is going to be most difficult. It should be remembered that the Fed exited twice from QE and entered twice, so it had three QEs.
One issue is to do it properly, but the other challenge that the ECB has is sequencing: whether getting out from negative rates or from QE should come first. It could be argued that, if negative rates can be escaped from first, the impact on long-term rates will be in the same direction, so more QE should take place, which could be a paradox arising from trying to exit by doing more. This debate may be taking place in the Governing Council and, hopefully, a lot of discussion and thinking is going to happen, but it is certainly not clear to the industry how things will happen.
In comparison to the US, where the banking system is now addressing a situation of a yield curve that is much steeper, the prospects in Europe of exiting from all this with a yield curve that will be flatter may be even more worrying. The monetary policy should not be regarded only in the interests of banks, because it is in the interests of the economy as a whole, and they also have to remember that the current monetary policy has reduced the cost of risk to levels which are very low. This is very positive for the banking industry and for the financial system as a whole. There is a more stable environment, but the challenges will come ahead.
1.3. The adoption of unconventional monetary policies in major advanced economies has had a far-reaching fallout in term premia and exchange rates everywhere, accentuating the global financial cycle
An official underlined one particular element that has not been mentioned, which is the spill-over effects of these policies, particularly in emerging markets. These policies tend to increase local financial exuberance and to boost local credit markets. Perhaps the effect of QE has not worked very rapidly in advanced economies, but it did work in emerging markets through spill-overs, rising asset prices and the appreciation of exchange rates. That made life more complicated for policymakers trying to manage their own financial and business cycles. This has to be thought through. There is perhaps a coordination policy problem here, and of the solutions to mitigate excessive cross-border financial spill-overs might be to use macro prudential policies. Much work has been done at the BIS but also at the IMF on macro prudential and spill-overs, so this also has to be taken into account. Overall, however, what is being done is working, and the bold actions of central banks should be commended. These policies have helped to mitigate the direct and indirect effects of the crisis. Achieving a smooth coordination will perhaps be the most difficult part.
2. Precautions need to be taken regarding the exit of the ECB’s quantitative easing
The Chair moved to the second issue: thinking about monetary policy in the Eurozone for all Member States. They asked whether ending ultra-loose monetary policies, or QE, is a feasible target given the different economic circumstances across the Member States, and whether there are precautions that might need to be taken in that environment, given the high levels of debt in some countries.
2.1. Deleveraging process, financial fragmentation and communication challenges
A banker stated that Europe could learn from the US experience. Looking at how QE was implemented, there were many concerns in the beginning. In fact, the US starting exiting QE maybe too hastily with the taper tantrum and had to improve its ways of communicating to markets, but overall the on-going exit process in the US seems to have been managed in a fairly good manner. Markets have been shaken to an extent, but that is unavoidable. There remain challenges ahead, but now they are talking about reducing the balance sheet, so maybe this needs to be looked at as a less dramatic issue. One thing is timing, and there is a need to be careful in this space: in Europe, there were some experiences that arose from exiting a little too early, or being a little too late in doing certain things.
Another issue is what the transmission mechanism is. The QE in the US has in particular facilitated the deleveraging of the private sector in particular, more than the public sector. This deleveraging has taken six years to take place, however, and in Europe there have only been two years of QE. Looking at long-term interest rates compared to the rate of growth of the economy, it is only over the last two years that there has really been a rate of growth in the economy that is higher than the interest rate. The deleveraging process is ‘snowballing’, so one has to be sufficiently patient.
In addition to this, the banking system is not functioning very well in Europe; there is still much fragmentation. There has been an impact from the regulatory changes that have taken place recently, and the redenomination risk is still present. These are elements that have to be taken into consideration when calibrating the exit, and not wanting to do things too quickly. Fragmentation, in particular, remains an important element to take into account. Withdrawing liquidity in a situation where liquidity is abundant but is not circulating well enough in the system – which, in the current environment, could be considered a paradox –could produce quite some negative reactions.
An official stated that fragmentation is more benign now, compared to several years ago. If there are independent fiscal authorities, it is natural to have some degree of differentiation in terms of sovereign-risk premium. This does not necessarily mean that there is a loss of effectiveness in policy.
There has also been discussion about the prolonged usage of APPs and QE, and withdrawal from that needs to be very carefully communicated. This always revolves around communication, in terms of where the neutral rate is, and what inflation expectations and targets are aimed for. This has been done quite skilfully by, for instance, the first central bank that has been normalising now. In this process, those other institutions that are in different phases of the cycle will also be capable of making very good use of the communication strategy, to ensure that the process is carried out very smoothly.
2.2. Taking into account the evolution of the economic situation
The Chair asked whether markets and these countries would cope when policy is no longer as accommodative as it is today, when the ECB feels comfortable that inflation is self-sustained and that they are at their objective of close to, but below, 2%.
A central banker replied that the mandate of the ECB is price stability, and the question of debt levels is therefore only relevant insofar as it is relevant for price stability. This does not enter into the discussion directly, and nor should it; it is obvious that every exit is a very difficult operation. It is dangerous to be premature, but on the other hand, Europe does not want to be ‘behind the curve’.
A very clear policy decision for 2017 was made by the ECB Governing Council in December 2016. The programme of asset-buying will go on until the end of this year, with certain reduced volumes. Beginning from 1 April, €60 billion will be bought per month, instead of €80 billion. It is also important that these are realistic numbers, so there will be enough material to buy. For this year, then, there has been a clear decision.
Then, starting in the summer, there will need to be an examination of how the economic situation is evolving and how stable developments are obtained. There is a need to look at what risks are still there.
There is one element of disagreement between two members of the panel: the speaker does not perceive there to be redemonination risk. The markets do not question the existence of the euro. The euro is ‘here to stay’, although there are a lot of other risks around, and these will need to be monitored. A banker agreed that in Europe, people are used to saying that there is no redenomination risk but, when going outside Europe, the question still exists. In Beijing a month ago, a leader stated that, within five years, the euro area will be gone, or at least one or two countries will have left it. They were then asked whether this was true. Of course, people in Europe ‘have to preach’, but people outside Europe are less confident, and are looking at election results very closely. This is a redenomination risk that cannot be hidden; it is still there. Monetary policy should not compensate for this, but it should take this into account. In this very delicate environment, this is just one of the other elements. The markets are waiting for signals, because they have been told for years by Nobel prize winners that the euro area cannot work because it is not in line with optimal currency areas.
A central banker noted that this is nothing new. In the Anglo-Saxon world, some people have been saying this since the creation of the euro, for different reasons. Some of them might be scientific reasons, and others might be self-interested reasons. It is interesting – and this can be observed empirically – that at one time, the markets were influenced by a redenomination risk, but this is not the case now. The voice of the markets is a positive one.
3. To encourage economic recovery and increase potential economic growth, structural reforms are indispensable
3.1. Monetary policy, even in extreme forms, was never intended to be a substitute for structural reforms
The Chair asked about the role of monetary policy, and whether monetary policy is sufficient to revive growth, consumption and investment in the real economy, focusing on Europe.
An official stated that if there was one ‘silver bullet’ for problems, it should be used, but the answer is a little more complicated. Central banks have done a great deal, and that needs to be appreciated: they have helped to avoid another depression. By making sure that the social fabric stuck together, they have helped to resist protectionism and populism, although these elements have eventually returned, as in many other crises.
Central banks were not supposed to do everything. Monetary policy, even in extreme forms, was never intended to be a substitute for structural reforms or for growth-enhancing reforms, and was also never intended to be the only macro economic policy in use. Essentially, it became the ‘only game in town’ due to political-economy problems, such as gridlocks in parliaments and in decision-making processes. After a first coordinated G20 initiative, the world evolved into a ‘tragedy of the commons’, wherein they could not employ the whole array of policies that were at hand.
There is a need for understanding that blame should not necessarily be attached to policymakers. Reforms are complicated and necessary and should make good use of the time that monetary policy can buy to engineer structural reforms. However, structural reforms are not easy: they create winners and losers, and they is always a time inconsistency problem between the benefits and the costs. It is, therefore, always very complex to make sure that everyone is convinced of what the right levels of inflation, debt and taxes are, and that this is consistent with the type of social welfare benefits that a society desires. Unanimity is very difficult. The role for monetary policy in a crisis is to do the utmost, but also to create the conditions for societies to engineer structural reforms.
For that, a little more growth is required, and this is being achieved in Europe, so things are moving in the right direction. There need to be skilful politicians and some fairness in burden-sharing, and a little bit of luck is also required. If that is beginning to happen, hopefully Europe will also reflect on what types of structural reform are needed. These will likely have to do with the growth model and sustainable environment policies that will change technologies, and also, particularly in advanced economies, more social inclusion and fairness. These would be good things for social, political, economic and financial equilibrium. If monetary policy could be the first leg of this, hopefully this will be followed by a period of fair and profound structural reforms in Europe.
3.2. Monetary policy cannot be the only game in town
A central banker stated, for the sake of future generations, potential economic growth in the euro area should be boosted. Unfortunately, this is nothing monetary policy can deliver. This requires policies that set the right incentives for investment. To push forward economic recovery and raise potential economic growth, structural reforms are indispensable. The sooner the structural reforms are implemented, the stronger and more sustainable the recovery will be.
3.3. Mutual respect between independent central banks and democratic governments is essential
A central banker stated that the world that everyone is living in is one of, on the one hand, independent central banks – and there are very good reasons for their independence – and, on the other hand, democratically elected governments. There needs to be mutual respect between these; the independence of central banks should be fully recognised but, on the other hand, central banks should also not try to be perceived as over influencing democratic governments. What can be provided is economic expertise, and expertise may also be offered in fields that go beyond monetary policy.
For a central bank to apply pressure to a democratically elected government, however, would be inadequate. There has to be a dialogue, but one based on mutual respect. In some countries, unfortunately, there is a growing tendency to have a negative discussion on the independence of central banks, and care is required in relation to this. People need to be clear about the purpose of a central bank in a democratic society. The ECB has found the appropriate role; it pursues a dialogue with the political institutions, but as an independent player, and that is how it should be.
A banker stated that in 2011, the central bank tried to push certain governments to make reforms, and this had a mixed result. Malta has made a lot of reforms with the same monetary policy as Italy, which has made fewer reforms, and other countries, which have done differently. Central banks should not rely on monetary policy as an instrument to influence governments.
An attendee asked whether there is not some complacency in this perspective whenb affirming that there is no redenomination risk and no fragmentation, when TARGET2 balances are back to what they were in 2012. She is all for saying that the euro is ‘here to stay’, but as an international investor, although the ECB has been telling a ‘nice story’ that this just reflects the ECB or its asset-purchasing operations, there is a question as to why the money is not circulating. It gets stuck in Germany, despite all of this liquidity. She asked whether, if there were a properly functioning banking system, Europe would see these large balances, and whether the ECB is taking into account the existence of this fragmentation and perception of risk in the conduct of its policy and in its thinking about the exit strategy.
A central banker stated that there is a certain element of fragmentation, but it is much smaller now. It must not be forgotten that Europe now has a banking union, so huge progress has been made. This afternoon, there will be a discussion at the Ecofin meeting about non-performing loans. This is a discussion based on exactly the same definitions of non-performing loans, which did not exist three or four years ago. That means that they have better information and better instruments to deal with this. It would take a long time to talk about TARGET2, but there have been studies by the Bundesbank and the ECB that show that this has nothing to do directly with fragmentation; it is more to do with certain technicalities of the APP.