Monetary policy beyond maintaining price stability

Lucrezia ReichlinLondon Business School and CEPR

ECB watchers 2014Frankfurt

March 12th

Key problems in the euro area today

• Inflation: declining, expectations below target, ECB forecast negative surprised

• Banks’ fragility and in the process of deleveraging (AQR)• Legacy debt (banks and sovereigns)• Financial segmentation causing heterogeneity in

financial conditions and impairment of monetary policy transmission

• Finally the recovery is there but nominal GDP weak• Weak M3 and credit

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-6-4-202468

101214

Euro Area

Loans (HH+NFC) GDP M3YoY growth rates.Sources: ECB, OECD

Nominal GDP, credit and M3

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Euro Area inflation and SPF forecasts (ECB)

InflationExpectation

Forecast: Average of forecasts - Harmonised ICPPoint forecast - Target period ends 12 mafter survey cycle begins

1999Jan 2000Dec2002Nov2004Oct 2006Sep2008Aug 2010Jul 2012Jun-2

-1

0

1

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Countries: Inflation (YoY HCPI, ECB)

Germany Spain FranceItaly Euro area

Inflation

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11

Jul 1

1No

v 11

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12

Jul 1

2No

v 12

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13

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3No

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0.0

0.5

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3.0

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1No

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ECB systematically surprised

% year-on-year

2011 2012 2013 2014

ECB forecastEurostat flash (October)

Sources: ECB, Eurostat

1998

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0.0

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Non performing loans / total loans

France Germany Italy SpainSource: FRED, IMF

Growing non performing loans

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0100200300400500600700800900

1000

Germany

NFC HH MFIs Gov

100 = nominal GDPSource: calculation on ECB data

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0100200300400500600700800900

1000

Spain

NFC HH MFIs Gov

100 = nominal GDPSource: calculation on ECB data

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0100200300400500600700800900

1000

France

NFC HH MFIs Gov

100 = nominal GDPSource: calculation on ECB data

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Italy

NFC HH MFIs Gov

100 = nominal GDPSource: calculation on ECB data

Total liabilities as % GDP not declining

In this situation ….. divine coincidence

Achieving price stability would help financial stability as well by easing the debt burden and facilitating the macro adjustment

Problems:-- how to do it at the ZLB-- the fundamental problem of the adjustment in the euro – financial balkanization in response to shocks – is the key problem for both price and financial stability … the euro area is facing a specific problem which has to be addressed creatively but it is facing difficult tradeoffs between stability and moral hazard … the ECB has to experiment with new tools and clarify its view on those tradeoffs

HOW HAVE THESE TRADEOFFS BEEN DEALT WITH BY THE ECB EXPERIENCE SINCE THE CRISIS?

ECB since the crisisnon-standard tools

PHASE 1: • First wave of market segmentation drying up of the non

domestic inter-bank market • The ECB responded by substituting for intra-euro area market

transactions via the LTRO (financial stability and price stability objective)

• Successful on both grounds (loans resilient, financial sector survived) but increasingly clear that insolvent banks were kept artificially alive

ECB since the crisisnon-standard tools

PHASE 2: • As the euro crisis developed, the flight to quality took the

form of non domestic investors withdrawing financing to either sovereign or banks.

• This led to a situation in which sovereigns had to intervene to save the banks while domestic bank took increasingly more domestic sovereign debts.

• The link between the sovereign and banks was exacerbated by the emergence of redenomination risk which led banks to hold domestic assets to match their increasingly domestic liabilities combined with side effects of the LTRO which created incentives to hold government bonds to use as collateral

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Q30%

1%

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5%

MFIs (excl. ESCB): Government securities/total assets

CEPR recessions Extra EA Other EA DomesticSource: ECB

Increasingly banks become holder of domestic government bonds

2006Jan

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MFIs (excl. ESCB): Domestic gov. bonds/total assets

Germany Spain France ItalySource: ECB

Effect is larger in the periphery but home bias is pervasive

ECB since the crisisnon-standard tools

… PHASE 2: • The consequence was the banks-sovereign “vicious

loop” leading to correlation between banks and sovereign risk

• This, combined with delayed banks’ deleveraging in view of the AQR and the accumulation of non-performing loans …

lead to both price stability and financial stability problems

ECB since the crisisnon-standard tools

… PHASE 2:

In this situation LTRO2 was less effective than LTRO1 both for stimulating the economy via supporting bank lending and for dealing with financial stability issues essentially driven by solvency issues (not dealt with) and disruption of geographical financial diversification

…. FEW OBSERVATIONS

1. Weak loans:a puzzle given aggressive ECB action?

2001Jan 2003Jan 2005Jan 2007Jan 2009Jan 2011Jan 2013Jan-25000

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Loan flows (6m MA) and industrial production

NFCIndustrial production (right)Source: ECB

1999W012000W432002W332004W232006W122008W022009W442011W330

200000

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Main refinancing operationLonger-term refinancing operations

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6Real interest rates

Germany Spain FranceItaly

Lending rates to NFC (Up to 1 year)-CPI.Source: ECB

2. Although liquidity was provided especially in the periphery, nominal and real lending rates remain heterogenous

3. The second recession was specific to the euro area – the US avoided it

The Euro Area had a second crisis – not the USQ

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YoY real GDP growth

CEPR recessions Italy Spain US Euro AreaSource: OECD

4. And, unusually in historical experience, the second recession was driven by the periphery

19821 19834 19853 19872 19891 19904 19923 19942 19961 19974 19993 20012 20031 20044 20063 20082 20101 20114-6

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GDP YoY growth rate contibutions

France Germany Italy Spain Others Others (included Spain)Euro Area

Sources: Eurostat, national banks, ECB Area Wide Model

Mostly driven by the peripheryUnusual in historical perspective

A key factor in explaining these four facts ….

• In a monetary union, a key feature of the adjustment process is that, in response to a negative shock, financial integration goes into reverse (not the same as flight to safety, rather everybody goes home!)

• Both the home bias in government bonds and in the inter-bank funding are part of this story

• The LTRO can address the inter-bank problem by replacing non-domestic funding but tools to deal with the home bias in sovereign market have not been tried although the banking union project when completed would help

Need new non standard policies but again no contradiction between price stability and financial stability, rather tradeoffs which have to do with interaction between monetary and fiscal issues

A quantitative exercise and a proposal

The quantitative exercise: what have been the BIG changes in banks’ balance sheets?

The proposal:Create incentives for banks to hold geographically diversified sovereign

Banks’ balance sheets: big changes since 2008Liabilities: funding stress is from non-residents from 2008

Banks’ balance sheets: big changes since 2008Assets: shift from loans to government bonds since 2011

Garicano-Reichlin’s Proposal

In this context regulation on sovereign bonds and their risk weighting can be used as a monetary policy toolSovereign bonds are not risk free but market pricing is distortedA possible solution• Impose as a rule that, for sovereign bonds to have a risk free weighting, they

must be held by banks in certain constant proportions, for example relative to GDP.

• Although a transition regime will need to be established to avoid hurting banks in the periphery, such proposal would, by dramatically reducing the exposure of banks to their own sovereigns, help to break the link between banks and sovereign risk.

• We also anticipate that such a regulatory initiative bias could help to encourage the emergence of the market driven creation of a euro area safe asset