Brussels, 9 June 2016 - On the importance of policy alignment to fulfil our economic potential 5th Annual Tommaso Padoa-Schioppa Lecture by Mario Draghi, President of the ECB, at the Brussels Economic Forum 2016,
In a speech in Vienna last week, I explained why monetary policy could deliver the appropriate level of stimulus to the economy, even in a setting where interest rates are close to their effective lower bound.[1] As inflation is ultimately a monetary phenomenon, a committed central bank can always fulfil its mandate. And that is true independently of the stance of other macroeconomic policies.
But monetary policy does not exist in a vacuum. The situation of central banks is better described as independence in interdependence, since other policies matter a great deal. They can buttress or dilute the effects of our policy. They can slow down or speed up the return to stability. And they can determine whether stability is accompanied by prosperity, which is directly relevant to the social cohesion of the euro area.
It is these interactions, and why they matter, that I would like to talk about today.
Policy interactions in stabilising the economy
The objective of the ECB is defined as delivering a rate of inflation below but close to 2% over the medium term. But the medium term is not a fixed period of time. When faced with adverse shocks, the pace at which monetary policy can bring inflation back to the objective depends on two factors: the nature of the shock itself, and the conditions in which monetary policy operates.
Some types of disturbance will inevitably depress inflation for longer than others and make the return to the objective slower. The recent succession of global oil supply shocks is a prime example. In that context, the job of monetary policy is not to fight short-term shocks to prices, but to prevent them from feeding into longer-term inflation dynamics – or put another way, it is to make sure that the effect of shocks on inflation is no more persistent than it needs to be. So when we talk about returning inflation to our objective without undue delay, this is what we mean. The return to price stability should take no longer than implied by the nature of the shocks we are facing.
But this is not entirely dependent on our actions, due to the second factor – the conditions in which we operate. Monetary policy can act decisively to support demand, to stabilise inflation expectations and to avert second round effects on wages and prices, which is exactly what the ECB has done over the past two years.[2]But the orientation of other policies also influences the speed with which output returns to potential. So if other policies are not aligned with monetary policy, inflation risks returning to our objective at a slower pace.
There are a number of policy areas that matter in this regard.
First, for monetary policy to stoke demand and inflation, it matters crucially whether the financial system is able to relay our policy impulses efficiently to the economy. In the euro area that transmission mechanism has been impeded repeatedly in the past, initially by rising risk premia linked to unwarranted fears about the survival of the euro area, and later by widespread bank deleveraging.[3] That has diluted the effectiveness of our stimulus and lengthened the “long and variable” lags over which monetary policy works.
We have compensated for this by designing our measures to remove transmission blockages, as well as including an asset quality review in the comprehensive assessment of bank balance sheets that we launched in 2013. Both measures have helped ease financing conditions, as we can see in our bank lending surveys. But bank balance sheets have not yet been fully repaired, as illustrated by the high stock of non-performing loans in some parts of the euro area. So more work-out of these non-performing assets will have to take place, and the conditions for that will have to be put in place by the right policies and authorities.
Second, it matters for monetary policy whether fiscal policy is steering aggregate demand in the same direction, and how strongly. Fiscal policy was contractionary for several years in the euro area following the loss of confidence in sovereign credit in 2010, and the negative effect on growth was exacerbated by the fact that consolidation in some countries was implemented mainly through tax rises rather than current spending cuts.[4] This placed the full burden of macroeconomic stabilisation on monetary policy. And in a context of disrupted transmission, that has led to a slower return of output to potential than if fiscal policy had been more supportive.
This is why the ECB has said many times that fiscal policy should work with not against monetary policy, and the aggregate fiscal stance in the euro area is now slightly expansionary. But supporting demand is not just a question of the budget balance, but also of its composition, especially the tax burden and the share of public investment. So we should not see fiscal policy as solely a macroeconomic tool, which is only available to countries with strong public finances. We should also see it as a microeconomic policy tool that can enhance growth even when public finances need to be consolidated.
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