1

Monetary policy in the euro area

during the crisis and after

Salvatore Rossi

Banca d‟ItaliaManaging Director

Research, Economics, International Relations

Capital Markets in the Post-Crisis Environment

Rome, April 7, 2011

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Timeline

• August 2007 → Turbulence starts

• Sept/Oct 2008 → Financial crisis intensifies

(Lehman)

• December 2009 → Exit (phasing out) begins

• May 2010 → Sovereign debt crisis

3

Phase 1 (from August 2007 to September 2008)

• Money markets are impaired: spreads between unsecured

and secured borrowing increase, reflecting lack of confidence

among market participants

• The ECB extends the length of its refinancing operations to 6

months, while increasing the frequency of the 3 months ones..

• ..and accommodates banks‟ preference for “front loading” the

fulfillment of reserve requirement

4

Source: ECB

The money market spread(Euribor-Eurepo, 3-month)

9 August 2007

15 September 2008

0,0

0,2

0,4

0,6

0,8

1,0

1,2

1,4

1,6

1,8

2,0

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11

turbulence

starts

financial crisis

bursts

phasing out

starts

3 December 2009

sovereign crisis

starts

7 May 2010

5

• Turmoil turns into a true global financial crisis; severe impairment

of all financial markets

• Banks increase demand for precautionary reserves and tighten

credit conditions

• The crisis strikes the real economy, causing the deepest

recession since the Great Depression of the ‟30s in most

advanced economies

• The ECB rapidly lowers key interest rates and implements a set

of non-standard measures

Phase 2 (from September 2008 to December 2009):

the crisis intensifies

6

0%

20%

40%

60%

80%

100%

2002 2003 2004 2005 2006 2007 2008 2009 2010

% banks saying liquidity has not changed or improved

% banks saying liquidity has worsened

Source: ECB Money market survey, 2010

Banks’ assessment of market liquidity conditions

in the unsecured segment

7

Source: ECB

The ECB official rates

0

1

2

3

4

5

6

Jan-

07

Apr-

07

Jul-

07

Oct-

07

Jan-

08

Apr-

08

Jul-

08

Oct-

08

Jan-

09

Apr-

09

Jul-

09

Oct-

09

Jan-

10

Apr-

10

Jul-

10

Oct-

10

Jan-

11

Apr-

11

EONIA

Main refinancing rate/minimum bid rate

Deposit rate

Marginal lending rate

8

The euro 3-month real interest rate(deflated by expectations of CPI inflation one quarter ahead)

Source: ECB and Consensus Economics

Well anchored inflation expectations allow the ECB to sustain the economy

through marked interest rate cuts: real 3-month interest rate is negative since mid-2009

-1

0

1

2

3

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

9

• Monetary policy action has gone beyond interest rate

cuts: it also includes non-standard measures

• They focus mostly on commercial banks, with the aim

at sustaining banks‟ funding and the flow of credit to

the economy..

• ..through new and enhanced modalities of liquidity

provision

The ECB’s multi-faceted response

to the global crisis

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Fixed rate full allotment tender procedures in all

refinancing operations

Expanding list of assets accepted as eligible

collateral

Extending LTROs‟ duration up to one year

Providing liquidity in US dollars and Swiss francs

CBPP: a program to purchase euro denominated

covered bonds issued in the euro area

Non-standard measures

(“enhanced credit support”)

11

The size of central banks balance sheets(Total assets; index, January 2007 = 100)

0

50

100

150

200

250

300

350

2007 2008 2009 2010 2011

European Central Bank

Federal Reserve

Bank of England

Source: ECB; Fed; BoE

12

• In the course of 2009 financial markets conditions gradually

improve. In December 2009 the ECB decides to

discontinue, in the following months, the 6- and 12-month

refinancing operations

• In March 2010 the ECB decides, starting from the end of

April, to return to variable rate tender procedures in the 3-

month operations (maintaining „full allotment fixed rate‟ for

1-month and 1-week operations)

Phase 3 (from December 2009 onwards):

exit (phasing out) begins

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Phase 4 (from May 2010 onwards):

the sovereign debt crisis

• In the spring of 2010 tensions emerge in some government

bond markets in the euro area (Greece, Ireland, Portugal)

• Interest rate spreads on government bonds vs. the Bund

increase sharply as a result of concerns about

sustainability of public finances

• Tensions spread to money markets: liquidity dries up again

• The phasing-out of non-standard measures is temporarily

stopped

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Government bond spreads w.r.t. to Bund

Source: Bloomberg

turbulence

starts

financial crisis

bursts

phasing-out

starts

sovereign

debt crisis starts

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

11.00

Jan-

07

Apr-

07

Jul-

07

Oct-

07

Jan-

08

Apr-

08

Jul-

08

Oct-

08

Jan-

09

Apr-

09

Jul-

09

Oct-

09

Jan-

10

Apr-

10

Jul-

10

Oct-

10

Jan-

11

Ireland Greece Spain Italy Portugal

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The Securities Markets Programme

• Tensions in government bond markets were undermining

the monetary policy transmission mechanism in the euro

area

• In May 2010 the ECB decides to purchase public securities

issued by euro-area countries (SMP), while keeping its

commitment to supply abundant liquidity to the system

• The objective of the SMP is to contrast “undue” volatility in

dysfunctional segments of the financial markets

• This did (and does) not imply monetary financing of

sovereign states or the creation of additional liquidity, as

interventions are temporary and sterilized

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The European response

to the sovereign debt crisis

• The EU Council agreed on a financial stabilization

arrangement under which countries of the euro area can

obtain loans at conditions as those applied by the IMF in

similar circumstances

• The bulk of the resources comes from the European Financial

Stability Facility (EFSF), a new body which funds itself on the

market by issuing securities guaranteed by the countries of the

euro area

• From 2013 onwards, the EFSF will be replaced by a

permanent body, the European Stability Mechanism (ESM)

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Where do we stand now in the euro area

• Monetary policy remains very accommodative: ECB rates

are at their lowest level ever

• Inflationary pressures are building up as the result of

surging commodity prices; overall, risks are on the upside

• Momentum of economic activity remains positive, credit

conditions continue to improve. However, risks are on the

downside, and uncertainty remains high

• Tensions in some sovereign debt markets also remain

high

• As recently stated by President Trichet, “the ECB is

prepared to act in a firm and timely manner”

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Market expectations about overnight rate (Eonia)

Source: Bloomberg

0,25

0,50

0,75

1,00

1,25

1,50

1,75

2,00

Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12

02/03/11 30/03/11

Month in which the maintainance period begins

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A tentative assessment

• The ECB operational framework has worked well, both

before and during the financial crisis

• The non-standard measures fit nicely in the existing

framework; they represent an exceptional response to

exceptional circumstances

• Before we eventually design the “new normal”, we need to

study carefully the lessons from the crisis

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Some lessons

• The run-up to the financial crisis has shown that price

stability is not a sufficient condition for financial stability

• Monetary policy should pay more attention than in the

past to developments in credit markets and to the

building up of financial imbalances

• Some simulations done at Banca d‟Italia with a model

based on Gerali et al.(*) show that, by responding to

credit dynamics, monetary policy may decrease the

volatility of output and inflation

(*) Gerali, A., S. Neri, L. Sessa, F. Signoretti “Credit and Banking in a DSGE Model of

the Euro Area”, Journal of Money, Credit and Banking, vol. 42, Sept 2010

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Interaction between monetary and

macroprudential policies

• Monetary and macroprudential policies interact as they both influence

financial stability and the transmission mechanism of monetary policy

• This interaction must be well understood and taken into account in the

formulation of the two policies

• Research done at Banca d‟Italia(*) shows that policy cooperation through

an appropriate institutional setup can improve financial stability

• The structure of the ESRB should ensure consistency between monetary

and macroprudential policies

(*) Angelini, Neri, Panetta “Monetary and Macroprudential Policies”

Temi di Discussione, 2011 forthcoming

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Thank you for your attention