Has European monetary policy reached a dead end?

Central bankers could lead such an easy and quiet life. They are independent, they have a clear goal – price stability – and they have a powerful tool to reach it – the interest rate. Along these lines, in 2000 Mervyn King claimed that: “A successful central bank should be boring.” He added that a central bank should be “like a referee whose success is judged by how little his or her decisions intrude into the game itself.”

Well, that was 17 years ago, and we all know that history can change course in an instant. That’s what happened in autumn 2008 when the financial crisis erupted. Looking back, the signs had been there for quite some time – hindsight is always 20/20. For about a year before the crisis, tremors in the financial system could already be felt.
But on 15 September 2008, the big earthquake finally struck. On that day, an American investment bank failed: Lehman Brothers. The US government did not step in to support it, confounding market expectations. That was a sound decision in principle, but it sent the markets into a tailspin. The panic button had been well and truly pressed.
Within a few days, the crisis had spread around the globe and brought the financial system to the brink of collapse. The situation eventually stabilised, but that was not the end of the story. In the wake of the financial crisis, the global economy entered what we now call the “Great Recession”. Shortly afterwards, the euro area went through a banking and sovereign debt crisis. And the life of central bankers? Well, it changed. Their institutions were no longer referees, as Mervyn King had said; they had become players in the game. For some time, it even seemed as if they were the only players on the pitch, in particular when other policymakers were unable to react quickly to the crisis.
Central banks became crisis managers. For the ECB, this meant that its goal remained the same – maintaining price stability. However, achieving that goal suddenly became much more difficult. It had to reach deeper into its toolbox than it ever had before. It had to find new ways to use existing tools, and even invent entirely new ones.
People see new tools of the ECB as something risky
All this made some people uneasy. Particularly here in Germany, people see the new role and the new tools of the ECB as something risky. They are concerned that the low interest rates might destroy future wealth and ruin their retirement plans. Outside Germany, however, the ECB has won respect for its forceful response to the crisis. People are focusing on the fact that the ECB helped to prevent worse things from happening. And some might even think that it could have done more.
So which view is right? Did the ECB save the euro and protect Europe from a crisis that could have been much worse? Or has it overreached and entered a dead-end road where it will eventually get stuck? This is a tricky question because, while it seems to focus on the past, it’s the future which holds the answer.
So let us do three things. First, let’s look back and ask what has happened so far. Second, let’s take a look at the present and ask where we are right now. And third, let’s look ahead and ask where we go from here.
The past – thinking outside the (tool)box
So the past is where we begin. In this case, 15 September 2008 – the day Lehman Brothers failed. And that was the death blow for something that was already severely wounded: trust. Banks around the world started worrying about their exposures to what were known as subprime mortgage loans. Through new financial instruments, the risks from these loans had been spread across the banking sector – in very opaque ways. Banks did not know how many of these risks were on the balance sheets of their business partners. And they did not know how to price these risks on their own balance sheets.
Trust disappeared; banks stopped lending to each other and the interbank market broke down. There was a high risk that even healthy banks would run short of liquidity and fail. That was a serious problem, given how important banks are for the economy. A meltdown of the banking system would have been fatal for the economy.
And it would also have been a problem for monetary policy and price stability. After all, the banks transmit standard monetary policy to the real economy.
At that point, the ECB deployed one of the classic tools of central banking. It stepped in as lender of last resort. It gave banks unlimited access to liquidity at longer terms and against a wider set of collateral. And it began to buy covered bonds, which were a prime source of funding for banks. The ECB’s goal was to keep otherwise healthy banks alive. Stabilising the banks was crucial to safeguarding price stability.
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The present – not quite there yet
So these are the measures that were taken. But where have they taken us? I think everyone would agree that they have taken us into uncharted territory. Some might say that they have taken us close to the limits of the ECB’s mandate. And others might even argue that they have taken us past those limits. At the same time, many people here in Germany argue that the ECB’s policy has many negative effects. They feel that low interest rates penalise savers, hurt banks and destroy wealth.
It is true, of course, that low interest rates have many effects. Some of these are intentional – they make it cheaper to borrow money, spur investment, revive growth and, eventually, stimulate inflation. But they also have unintended side effects.
So yes, for savers low interest rates do mean that their money accumulates at a much slower pace than before. However, most people are not just savers – they also need to borrow money from time to time. And that’s when low interest rates benefit them; when they borrow money to buy a house, for instance. The same applies to those who need a loan to set up a company.
It is a fact that monetary policy redistributes wealth. It always does, and there is no way around it. Low interest rates are good for borrowers and bad for savers. It’s exactly the reverse with high interest rates: they’re bad for borrowers and good for savers. But the ECB would not be fulfilling its mandate if these effects kept it from securing price stability. The ECB is responsible for price stability and price stability only. It is up to governments and parliaments to sort out redistribution policy.
Against that backdrop, the decision to lower interest rates was justified. And, in any case, what would the alternative have been? Savers might initially have been happy with higher interest rates, but the economy would have faltered. And over the medium to long term, savers would have felt that pain, too.
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The future – coming closer
Looking to the future, we can be confident that inflation will return to our objective. Thus, we need to think about how we can bring our unconventional measures to an end. We need to look ahead and design the exit. After all, it will be a major event for markets and the economy. And this links to another important issue: communication. For a long time, central banks and monetary policy were very opaque. In the 1980s, Alan Greenspan claimed that he had to learn “Fedspeak” when he became Chairman of the Federal Reserve Board. He “learned to mumble with great incoherence”. Back then central banks were secretive about monetary policy and vague, at best, when speaking to the markets.
So markets had to find ways to second-guess what the central bank was up to. Some of these ways were a bit odd. Alan Greenspan’s briefcase was one of the more inventive indicators. Whenever the Federal Reserve had a meeting to discuss monetary policy, the markets apparently observed Alan Greenspan’s briefcase. If it was bulging, markets concluded that interest rates would change; if it was thin, they concluded that no change was likely.
In the end, such ways of gauging what the central bank is up to are quite unreliable. Markets might easily draw the wrong conclusions and this might lead to unwanted volatility and turbulence. That is one of the reasons why today, almost everyone agrees that central banks need to be transparent. It helps them to steer the expectations of markets and make their policies more effective. At the same time, it helps them be more accountable. Both of these things have become even more important against the backdrop of our unconventional measures. So we need to communicate very carefully on our next steps. We must help markets get an idea of what the exit will look like. And we mustn’t confuse them with vague or ambiguous ideas. We have to strike a delicate balance. And in my view, we need to find this balance now.
As of today, it is clear which sequence the exit will follow. Bond purchases will come to an end, while interest rates will remain low, well past the horizon of net asset purchases. But we still need to decide on a timeframe. From my point of view, it is important that we really move towards the exit – step by step, but steadily and in a clear direction.
Summary of the speech by Sabine Lautenschläger, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, Hohenheim University, Stuttgart.

Source: https://www.ecb.europa.eu