FRANKFURT – Konrad Adenauer, Germany’s first chancellor after World War II, famously said: “Why should I care about the things I said yesterday?” What he meant was that events can sometimes unfold at a speed that outpaces our ability to understand them. So, as 2014 winds down, it is worth asking ourselves, with the benefit of hindsight: Have we at the European Central Bank reacted swiftly enough to maintain price stability in the face of threats, as our mandate requires? I think the answer is yes.
We noticed that our monetary policy was no longer having the effect on private borrowing costs to which we were accustomed. It was obvious that the lending channels in the banking system had become dysfunctional; excessively restrictive borrowing conditions were suppressing demand. In response, the ECB did precisely what any central bank would have done: we acted to restore the relationship between our monetary policy and the cost of borrowing, aiming to bring down the average rate that households and firms have to pay.
In June, we introduced a series of targeted longer-term refinancing operations (known as TLTROs) to provide funding for banks at very low fixed rates for a period of up to four years. The TLTROs were designed to maximize the chances that banks would pass on the funding relief to borrowers. Our programs to purchase asset-backed securities and covered bonds were tailored to help lubricate further the transmission of lower funding costs from banks to customers.
Together, these measures offer a powerful response that addresses the root causes of impaired bank lending, thereby facilitating new credit flows to the real economy. And tentative evidence suggests that they are delivering some initial tangible benefits to the euro area’s economy.
At the same time, inflation has continued trending down. In November, annual inflation in the euro area fell to a cyclical low of 0.3%, largely owing to the sharp fall in oil prices since the end of the summer. But falling core inflation (which excludes volatile energy and food prices) also points to weak aggregate demand. And, indeed, the ECB’s latest staff projections entail a notable downgrading of the macroeconomic outlook.
Falling oil prices and the prospect of a prolonged period of low inflation also seem to have affected inflation expectations. Given the potency of the recent oil-price shock, the risk is that inflation may temporarily slip into negative territory in the coming months. Normally, any central bank would welcome a positive supply shock. After all, lower oil prices boost real incomes and may lead to higher output in the future. But we may not be able to celebrate. After all, because well-anchored inflation expectations are indispensable for medium-term price stability, monetary policy must respond to a risk of de-anchoring.
That is why the ECB Governing Council has reiterated its unanimous commitment to use additional unconventional instruments within its mandate should it need to address a prolonged period of low inflation, or should monetary stimulus fail to move our balance sheet toward its size in early 2012. This would imply altering the scope, pace, and composition of our measures early next year, and staff from the ECB and national central banks have stepped up technical preparations, so that further measures, if needed, can be implemented in a timely manner.
If we were to judge that the economy is in need of further stimulus, one option could be to extend the ECB’s outright asset purchases to other asset classes. But it is important to remember that asset purchases are not an end in themselves. They are an instrument, not a target, of monetary policy.
An important criterion for the choice of additional measures should be the extent of their influence over broad financing conditions in the private economy. For example, purchases of bonds issued by euro-area non-financial corporations (NFCs) would probably have some direct pass-through effect on firms’ financing costs. But, compared to other asset classes, the market for NFC bonds is relatively thin.
It would be a different matter if we were to decide to buy bonds issued by euro-area sovereigns – the only market where size would generally not be an issue. Interventions in this market would likely entail a stronger signal that the ECB is committed to maintaining an accommodative monetary policy for an extended period of time.
The effectiveness of interventions in the sovereign-bond market – that is, their ability to lower the borrowing costs of households and firms further – will also rest on the state of the banking sector. Higher capital ratios, lower exposure to bad loans, and more transparent balance sheets increase the chances that the ECB’s quantitative impulses will be transmitted to the wider economy.
That is why the completion of the ECB’s comprehensive assessment of banks’ balance sheets and the start of Europe-wide banking supervision will help revitalize sluggish lending in the euro area. In particular, increased clarity and transparency about banks’ balance sheets, together with a better-capitalized banking sector, will create a more supportive lending environment.
But a decision to purchase sovereign bonds would also need to build on and factor in the institutional specificities of the euro area, including the limits set by the EU Treaty. We take these limits very seriously.
The year ahead will be challenging and rife with uncertainty. But if the past holds any lesson, it is that, if our ability to fulfill our mandate is at risk, we will not hesitate to act.
Peter Praet is Chief Economist of the European Central Bank and a member of its executive board.