I. Euro Area Monetary Policy in Uncharted Waters1
1. The global financial crisis has substantially impaired the functioning of the financial sector of the euro area, raising several questions about the conduct of monetary policy. In particular, how effective have been the unconventional measures implemented by the ECB in dealing with tensions in the interbank market? Have these measures helped maintain price stability? Given the significant problems in the financial system, how effective is monetary policy in forestalling strong disinflationary pressure, particularly when policy rates are very low? Finally, how can policymakers balance the potential need for additional unconventional measures to fight deflation in the context of the euro area with an exit strategy?
2. With respect to the assessment of monetary policy’s effectiveness to deal with the crisis, the analysis suggests two findings. First, even during the crisis, policy rate changes have still been transmitted to market rates, albeit more slowly (the lags have become longer) and less effectively (as credit spreads initially increased and only recently eased), meaning that the policy reaction needed to stabilize the economy has become stronger. Second, the unconventional monetary policy measures implemented so far have helped the transmission by reducing the liquidity premia in money markets, and there is some evidence that these measures may have had some beneficial effects also on government bond term spreads in the euro area.
3. Given the severity of the financial crisis and the depth of the economic recession, the risk of deflation remains, however. While there are some tentative signs of improvement, it is unclear when the euro area economy will pull out of recession. Headline inflation has declined significantly mainly due to the sharp fall of commodity prices, but the deterioration of economic activity has also contributed. The large and increasing output gaps and growing unemployment are likely to depress further firms’ pricing power and wage demands. Deflationary pressures might intensify, if adverse feedback loops between financial and real sector continue, given that policy interest rates are close to the lower bound.
4. Hence, to counter potential deflationary pressures, the ECB will need to continue to consider all its options, while securing a safe exit strategy. Intensification of deflationary risks may well require the ECB to utilize further unconventional measures, but these measures should continue to be designed to allow for a nondistortive exit. Exiting from the measures already implemented by the ECB should be relatively straightforward, as bank demand for ECB liquidity should ease when market conditions in the banking sector normalize. The large amount of term liquidity provided by the ECB may prove more costly to mop-up quickly if necessary, but it should not overly aggravate a timely exit.
B. ECB’s Policy Response to the Crisis2
5. At the onset of the financial crisis, the ECB responded promptly with significant adjustments in its liquidity management operations. Liquidity was provided in large amounts, including at term maturities, and collateral requirements were eased to prevent them from becoming a constraint for increased ECB funding. While the overnight rate remained on average close to the policy rate target, term spreads surged, reflecting both a sharp rise in counterparty default risk and liquidity risk due to severe funding pressure at longer term maturities (Čihák and Harjes, 2008).
6. Meanwhile, the ECB emphasized in its communications the distinction between its two core functions: (i) liquidity management with the primary goal to mitigate the risk that protracted liquidity shortages turned into bank solvency problems; and (ii) ensuring price stability by choosing an appropriate monetary policy stance. The stress in money markets resulted in sharp spikes in spreads between unsecured and secured rates for term funds and affected the transmission of monetary policy in a crucial fashion. Nevertheless, the ECB insisted that its liquidity provision would not interfere with monetary policy objectives.3
7. As interbank trading ground to a halt in mid-September 2008, the ECB significantly stepped up its liquidity provision. This was achieved by: (i) introducing a new “fixed rate full allotment” tender procedure, including at six month maturity, thus granting banks access to essentially unlimited liquidity at policy interest rate at maturities of up to six months; (ii) extending further the (already long) list of collateral assets; and (iii) increasing the (already large) number of counterparties eligible to participate in ECB’s refinancing operations from 1,700 before the crisis to 2,200.4
8. In early May 2009, the ECB took further steps to help the banking system. In particular, it (i) extended maturity of long-term refinancing operations to twelve months; (ii) included the European Investment Bank into the list of counterparties for monetary policy operations to ease funding difficulties for SMEs; (iii) announced a program to purchase covered bonds to the amount of 60 billion euros; and (iv) announced that the extended collateral list will be in place till end-2010.
9. ECB’s measures helped to lower spreads in money markets. Following unlimited provision of longer-term funds at fixed-rates by the ECB, which began at the end of October 2008, term money market spreads dropped sharply and now correspond closely to measures of counterparty risk, while liquidity premia seem to have been eliminated (Figure 1). Spreads are still at elevated levels, but they are not likely to fall much further until perceptions of counterparty risk in the banking sector normalize.
Figure 1.Euro Area: Recent Developments of the ECB’s Liquidity Operations
Sources: DataStream; and Bloomberg.
1/ Euribor refers to “the best price between the best banks” provided by Euribor panel members.
2/ The liquidity premium is the difference between the Euribor - Eonia Swap spread and the CDS premium.
3/ The one-year banks CDS premium is the average of premia for the “best” five Euribor panel banks out of 24 with the lowest premium.
C. Has the Transmission Been Impaired?
10. The reduction of the policy rates has been transmitted to market rates, although the pass-through was less than full and varied across market segments and maturities. Given the tensions in the money market, short-term bank lending interest rates moved broadly in line with historical regularities versus the three-month Euribor rate. For example, from September 2008 to February 2009, bank lending rates on new loans declined by: (i) between 20 and 60 basis points for consumption purposes; (ii) between 50 and 180 basis points for house purchases; and (iii) between 70 and 250 basis points for non-financial corporations. At the same time, short-term money market rates dropped by around 300 basis points, and spreads declined but remained elevated (Figure 2).
Figure 2.Euro Area: Cost of Borrowing by Businesses and Households
Sources: Haver and IMF staff calculations.
1/ Corporate bonds 3–5 year maturity relative to 5-year benchmark government bond index.
11. To gauge the effectiveness of the monetary policy transmission, it is, however, necessary to look beyond the interest rate response. In particular, analyzing only the transmission of policy rates to market rates is insufficient for assessing the effectiveness of monetary policy in achieving its ultimate goal of price stability. In that regard, the effective functioning of all transmission channels, namely, the interest rate, the bank lending, and the broad credit channels, is key. Also, the ability of the central bank to maintain inflation expectations in line with the definition of price stability is crucial for the effective working of the transmission mechanism.
12. A comprehensive analysis was conducted to determine various aspects of the effectiveness of monetary transmission (for details see Čihák, Harjes, and Stavrev, 2009). Several bi-variate VARs, comprising the policy rate and a set of market interest rates, are used to assess the pass-through of policy rates to several market rates pre- and post-crisis by comparing the impulse responses of the models estimated over the pre-crisis sample and the full sample. This is combined with a theory-based framework to analyze in a general equilibrium setup the functioning of all channels as well as the role of expectations. The relative importance of each channel and the role of expectations are assessed by looking at the variance decomposition. The functioning of the transmission mechanism pre- and post-crisis is evaluated by comparing the impulse response to standard shocks (demand, supply, and monetary policy) from models estimated over the pre-crisis sample and the full sample. For both models, the residuals are used to gauge the degree to which the functioning of the channels was affected by the crisis.
13. The VAR analysis shows that policy rate changes have been transmitted to market rates, although the degree and the speed of pass-through vary. The impact on 3-month Euribor rate is close to one-for-one and the speed of adjustment is fast, with the maximum impact transmitted within a month. The initial impact on corporate bond yields and new loans to non-financial corporations is similarly quick, although the full adjustment is more protracted and the impact on higher-grade bond yields is smaller than on lower-grade bond yields (0.6 to 0.7 percentage point for AA- and AAA-rated bonds versus 1.2 for BBB-rated bonds). However, the pass-through of the policy rates on loans to households for house purchases is somewhat smaller and the speed of adjustment slower.5
Euro Area: Pass-through of ECB Policy Rate to Market Rates
Sources: ECB, Haver, and IMF staff estimates.
14. The results suggest that the pass-through to all market rates has slowed and become somewhat less reliable during the crisis. In particular, impulse responses from the bi-variate VARs (in first difference) imply that the time for the full adjustment of market rates has increased to over 12 months, from between 3 months and 6 months before the crisis (the results from the bi-variate VARs in levels estimated both with OLS and Bayesian methods show a similar picture). The transmission to lower grade corporate bonds seems to have been particularly affected—the initial response of the BBB-rated corporate bond yields has switched from positive before the crisis to negative thereafter (Figure 3). The behavior of the residuals for the market rates suggest that the transmission has become less reliable, with larger residuals since the beginning of 2008, and in most cases significantly so (Figure 4). Analyzing the pass-through to market rates after the crisis, IMF (2008) also provides empirical support for the less efficient pass-through over the past year, pointing to the dislocation of the markets for short-term bank financing as the most likely cause.
Figure 3.Euro Area: The Impact of Crisis on Policy Rate Pass-through
Source: IMF staff estimates.
Figure 4.Euro Area: VAR Residuals of Market Rates
Sources: ECB; and IMF staff estimates.
15. More importantly, as bank lending standards have tightened following the crisis, quantity effects may be at play that could further impair monetary policy effectiveness. Indeed, the role of the interest rate pass-through for monetary policy effectiveness needs to be viewed in the context of tightening lending standards. While interest rate pass-through provides an important signal for monetary policy effectiveness, in times of significant stress in credit markets quantities are also important. Indeed, the April 2009 ECB bank lending survey suggests further tightening of lending standards, albeit at a slower pace. In this situation, banks may have significantly reduced lending by cutting loan originations rather than raising interest rates. Also, the shift of loans from special investment vehicles back to banks’ balance sheets, the so-called re-intermediation, as well as continuing funding pressures for the banks may put additional pressure on banks’ capital needs, thus slowing further new credit creation.
Theory-based (general equilibrium) framework
16. Impulse responses from the theory-based model support the results from the VARs that after the crisis the overall transmission has slowed. For both supply and demand shocks, the policy reaction needed to stabilize the economy is somewhat stronger, with the time needed for the policy feedback to pass through rising to about 2½ years, from about 1½ year before the crisis (Figure 5, first column). Similarly, the time for a full transmission of monetary policy shocks to inflation has increased after the crisis to close to three years, from about two years before the crisis (Figure 5, upper right panel). Compared with the findings from the VAR, these results suggests that not only the first stage of the transmission, the pass-through to policy rates, but also the overall working of the transmission mechanism seems to have become less effective after the crisis.
Figure 5.Euro Area: Effectiveness of Monetary Policy
Source: IMF staff estimates.
17. Another sign of the decreased efficiency of transmission is the significant decline of inflation expectations in the last quarter of 2008. Inflation expectations derived from the model declined notably in the fourth quarter of 2008, but as policies eased significantly to counter the strong disinflationary pressures, inflation expectations recovered since the beginning of 2009. This development of the model-derived inflation expectations agrees with market-based measures of inflation expectations, although the latter were likely affected by dislocations in inflation-linked bond and swap markets. Note also the high correlation between the model-derived and market-based inflation expectations—about 75 percent.
Euro Area: Model and Market-based Inflation Expectations
Sources: Eurostat, Haver, and IMF staff estimates.
18. Going beyond the impact of the crisis on the transmission, the model results suggest that the interest rate channel is the dominant transmission channel. In particular, it accounts for over 30 percent of inflation variation and close to 50 percent of output variation. Importantly, the results imply a major role of expectations, which account for around 40 percent of inflation variation and about 30 percent of output variation. The results also suggest some role for the bank-lending and credit channels, which explain about 15 percent and 10 percent of output variation, correspondingly.
19. The above results are in line with findings in the literature. For example, Angeloni and others (2002) conclude that the interest rate channel is the most important for monetary policy transmission in the euro area. They also find that the bank lending channel plays a role, although its relative importance differs among euro area countries.
D. Monetary Policy and The Return of The Liquidity Trap
20. The ECB’s enhanced credit support measures introduced since October 2008 may have helped mitigate deflationary risks. Although these measures may have been primarily implemented to ease systemic liquidity risk in the banking sector and support the transmission of lower policy rates to money market rates, they may have also affected the term spreads of euro area government bonds. Such an effect should be expected, if markets increasingly interpreted the various unconventional measures implemented by the ECB as signaling low interest rates for an extended period. Also, the relative increase in money supply compared to government bonds may lower the yield curve if money and bonds are imperfect substitutes. A macro-financial model introduced by Bernanke, Reinhart, and Sack (2004) is used to study these effects (for details see Čihák, Harjes, and Stavrev, 2009).
21. Overnight interest rates have come close to their lower bound in many advanced economies, including in the euro area. Such situations in which conventional monetary policies become constrained or ineffective, despite the need for further monetary easing, were famously described as liquidity traps by Keynes (1936). The experience of Japan in the 1990s and 2000s and the possibility of deflation in the U.S. in the mid 2000s reignited interest in this topic. The emergence of deflationary risks in many economies across the globe has again brought this issue to the fore of many debates.
22. Central banks have three sets of practical measures with which they may be able to further ease the policy stance once the policy rate has reached its lower bound: (i) shaping the public’s expectations about future settings of the policy rate; (ii) changing the composition of the central bank’s balance sheet by providing liquidity to specific markets considered dysfunctional (“credit easing”); and (iii) increasing the central bank’s balance sheet beyond the level needed to set the policy rate at zero (“quantitative easing”).
Shaping the expectations about future policy rate
23. If a central bank can convince the markets that its policy rate will remain low for longer than markets previously expected, it may add further stimulus to the economy. Usually, central banks do not provide unconditional commitments for policy rates, especially over the medium term. Some central banks, including the U.S. Fed and the Bank of Canada, have recently emphasized that they expect to keep rates low as long a deflationary risks persist, or inflation remains significantly below the target. However, markets, if rational, may have expected this already and such market expectations may not be sufficient to avoid a protracted period of deflation. A much stronger signal than communicating to keep rates low as long as needed is the provision of term funds at the policy rate. While the ECB’s policy in this regard has initially been targeted at reducing liquidity premia in term money markets, further extension of maturity and explicit commitment to continue such operations for a clearly defined period is a powerful tool in adjusting and managing policy rate expectations.
24. A key characteristic of the current financial crisis has been the breakdown of several specific credit markets. In particular, markets for asset-backed papers, that were an important funding/credit source, especially in the United States, have dried up, as the sharp increase in credit risk for these securities virtually stopped any new issuance or secondary market activity. Given the importance of these markets in the United States, the Fed decided to intervene directly to restart private activity and bring down liquidity premia. The ECB initially supported such markets indirectly by broadening its collateral requirements, and more recently also announced direct interventions in the covered bond market. Such measures are targeted at restoring the transmission of policy rates. Moreover, if successful, they should also stimulate activity and lower the risk of deflation.
25. A permanent increase in money supply that would effectively raise inflation expectations would also have a stimulating effect on the economy. The monetary base can be expanded by open market operations, such as central bank purchases of assets, or by other (more “passive”) measures. Following the switch to the fixed-rate full-allotment tender procedure—implying that banks’ temporarily elevated demand for central bank reserves would be fully accommodated at the policy rate against eligible collateral—the Eurosystem’s balance sheet almost doubled, reaching some 16 percent of GDP in early 2009. In principle, for this expansion of the balance sheet to transmit to higher inflation expectations through the portfolio-rebalancing channel, a subsequent increase in other broader monetary aggregates would be required. However, markets may interpret the expansion as a signal that the ECB intends to keep policy rates at low levels, thus resulting in a flatter yield curve over the near-to medium-term. Quantitative easing carried out through outright purchases of long-term government bonds may flatten the yield curve further because of portfolio-balance effects, although in the absence of financial frictions, there should be no such effect (Eggertsson and Woodford, 2003).
26. The predicted yields from the model track actual bond yields very closely (Figure 6, left column). The estimates of the long-run “risk-free” yields during January 1999 to January 2009 are slightly above 3 percent. Short-term (two-year) model residuals (Figure 6, right column) do not have an obvious trend, but model residuals for long-term government bonds have been more or less consistently negative since 2004–05. This reflects the fact that, as in the United States, long-term rates did not rise much with short-term rates, as the ECB raised its policy rates. The residuals have fluctuated since the onset of the crisis, but turned sharply negative in October 2008 when the ECB introduced a host of new unconventional measures. As a result, the actual yield curve is lower and flatter than the predicted yield curve for the latest observation, January 2009 (Figure 6, lower panel).
Figure 6.Euro Area Macro-Financial Model: Government Bond Yields and Model Estimates 1/
Sources: DataStream; and IMF staff calculations.
1/ Euro area synthetic government bond yields.
27. The lower level of the yield curve may reflect the increase in the monetary base and the relative supply of money relative to bonds, as suggested by the portfolio rebalancing channel. Moreover, the flattening of the yield curve could reflect the perception, not backed by ECB communication, though, that through its non-standard policy actions the ECB would implicitly commit to keep policy rates low longer than implied by the simple VAR. However, the flattening has been most pronounced at the long end, while market expectations of an increased period of low policy rates should have a greater effect at the short end of the yield curve. Also, there are other possible explanations for the observed behavior in the residuals, including capital flows associated with “flight to safety.” Nevertheless, the fact that the level of the yield curve has been lower and the slope flatter over the past months than predicted by the macroeconomic variables is suggestive of some effect of unconventional measures on the yield curve.
28. Since the onset of the financial crisis, traditional transmission channels of monetary policy (interest rate, bank lending, and broad credit) have continued to operate, but at a lower efficiency. During the crisis, the transmission has slowed down (the lags have become longer), the policy reaction required to stabilize the economy stronger, and the transmission subject to more noise. Also, inflation expectations, while remaining broadly stable, declined significantly in the last quarter of 2008, reflecting the major deterioration in economic activity and requiring a strong policy reaction.
29. The ECB’s unconventional measures, such as the lengthening of its monetary operations and the increase in its balance sheet, likely have contributed to reducing term spreads in money markets. They may also have had some beneficial effects on government bond term spreads and the level of the yield curve. Given the potential for deflationary pressures, all options for further unconventional measures will need to be kept open. At the same time, care must be taken to continue to ensure that a credible exit strategy is in place.
AngeloniIgnazioAnilKashyapBenoîtMojon andDanieleTerlizzese2002 “Monetary Transmission in the Euro Area: Where do We Stand?” ECB Working Paper114.
BergerHelgeThomasHarjes andEmilStavrev2008 “The ECB’s Monetary Analysis Revisited” IMF Working Paper No. 08/171 (Washington: International Monetary Fund).
BernankeBenVincentReinhart andBrianSack (2004). “Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment” Board of Governors of the Federal Reserve Finance and Economics Discussion Series 2004–48(September).
BulířAlešMartinČihák andKateřina;Šmídková2008 “Writing Clearly: ECB’s Monetary Policy Communication” IMF Working Paper No. 08/252 (Washington: International Monetary Fund).
ČihákMartin andThomasHarjes2008 “Liquidity Management in the Euro Area” IMF Country Report No. 08/263 (Washington: International Monetary Fund).
ČihákMartinThomasHarjes andEmilStavrev2009 “Euro Area Monetary Policy in Uncharted Waters” IMF Working Paper forthcoming (Washington: International Monetary Fund).
EggertssonGauti andMichaelWoodford2004 “Policy Options in a Liquidity Trap” The American Economic Review Vol. 94 no. 2 pp. 76–9.
International Monetary Fund (IMF)2008 “Stress in Bank Funding Markets and Implications for Monetary Policy” Global Financial Stability ReportOctober (Washington: International Monetary Fund).
This is a summary of Čihák, Harjes, and Stavrev (2009, forthcoming).
For a full description of all measures taken by the ECB, see Annex I in the June 2009 ECB Monthly bulletin: http://www.ecb.int/pub/pdf/mobu/mb200906en.pdf
In that regard, as argued in Berger, Harjes, and Stavrev (2008), the ECB’s two pillar approach, which gives high prominence to monetary aggregates in assessing the policy stance, may have made communication more challenging. Buliř, Čihák, and Šmídková (2008) arrive at a similar conclusion.
The number of active counterparties before the crisis was about 450 (compared to 20 in the United States), which increased to 750 during the crisis.
These results are consistent with the finding by IMF (2008) that the 3-month Euribor rates have more stable and reliable relation with the policy rate than other lender rates.