NEWS Release - Behaving responsibly in a low interest rate environment: A central banker’s perspective - Speech by Yves Mersch, Member of the Executive Board of the ECB, Stiftung Marktwirtschaft: Expertentagung “5th Kadener Gespräch” - Alveslohe, 10 February 2017
The policy of the European Central Bank (ECB) is often said to be at the root of the current problems in the banking and financial sector. Particularly in Germany, there’s the added accusation of monetary policy “expropriating” savers.
A closer look quickly reveals that such hasty judgements fail to appreciate the complexity of the matter. Today, therefore, I shall examine carefully the underlying reasons for our monetary policy action. By focusing on the reasons for our actions we can understand more easily how to get back to a normalisation of monetary policy.
Low natural interest rates
Why are interest rates so low?
The growth trend has been declining in many mature economies not just since the crisis, but for several decades. This slowdown in growth has led to lower long-term interest rates.
The structural causes of this trend of slowing growth is a subject of controversy among specialists. Demographic and technological developments are mentioned, as are the effects of the financial cycle, which may be out of sync with the business cycles. I do not want to pre-empt this ongoing discussion. Instead, I would like to focus on two issues, which in the current context are very relevant from a monetary policy perspective – regardless of the structural causes underlying the weak economic growth.
First, the slowdown in growth in this environment increased the risk of a self-reinforcing downward spiral. For the weak growth dynamics will not go unnoticed by economic actors: their expectations are worsening. If, for instance, a company expects demand to fall, it will be less inclined to make big investments.
Secondly, ageing societies, which exist in many mature economies, not only have to cope with a shrinking labour force, but they also have to save more. This has led to a savings glut and to a shortage of safe assets. So investments are falling and savings are rising. This weakness of investment is further reinforced when public authorities invest less than is even needed to preserve the capital stock. This is a cause for concern especially where both fiscal space and demand exist.
This dynamic has led to a reduction in the natural interest rate, i.e. the real rate of interest in which savings and investments are in equilibrium in an economy operating at its potential, where there is neither upward nor downward pressure on inflation.
In the current environment, the ECB has brought the market rate below the level of the natural rate. The key rate since March last year has been at zero and the rate on the deposit facility at -0.4%.
Had we not done this, constant nominal interest rates amid falling inflation rates would have led to higher real interest rates and undermined anaemic growth even more. This would have significantly increased the risk of deflation. This is just as harmful as accelerating inflation. As Walter Eucken said: “Deflation distorts the price framework just as much.”[1]
Thus, price stability for the ECB means that we have to protect European citizens not only from inflation rates that are too high, but also from a deflationary spiral. This is reflected in our quantitative definition of price stability: an inflation rate of below, but close to, 2% in the medium term.
We therefore acted in order to abide by this symmetrical mandate on price stability.
But we are aware that we cannot lower our interest rates to an unlimited extent.[2] As from a certain level, it becomes more attractive to keep cash – despite the associated costs – than to pay negative interest rates. And even if this point has not yet been reached, we are bearing in mind that further rate cuts into negative territory may have non-linear effects. The reactions of people in extremis cannot be anticipated.
But we can also influence market interest rates in other ways. Thus, for example, with our asset purchases we have pushed the yield curve down. And by offering targeted longer-term refinancing on favourable terms which reward additional lending, we have made it possible for banks to cut their interest rates, a move which has led to increased lending.
All these measures in recent years have contributed to the economic recovery in the euro area.
Thus, both the demand for, and supply of, credit is rising.
In the real economy, too, positive surprises have predominated recently. The growth rate in the fourth quarter of last year rose to 0.5 %. In the euro area, the seasonally adjusted unemployment rate fell to 9.6% in December. In November it was 0.1 percentage point higher and in December of the previous year it was still at 10.5%.
Overall, the prospects for economic growth in the euro area are increasingly positive. However, while the data within the monetary union is pointing to growth risks being more and more in equilibrium, uncertainty and the risk of political shocks outside continental Europe have clearly gone up.
To put it another way: while the economic outlook for the euro area is steadily brightening, dark clouds are building up on the political horizon beyond the continent.
But of course we shall pay particular attention to how prices evolve. The annual rate of inflation rose, according to provisional estimates by Eurostat in January, by 0.7 percentage point to 1.8%. This sharp jump in the rate of inflation is largely attributable to volatile components, namely energy and, to a somewhat lesser extent, food. Core inflation, on the other hand, which excludes food and energy, remained stable at 0.9%.
For us, the overall inflation rate is the key figure because we protect the purchasing power of citizens, albeit in the “medium term”, not on a month-to-month basis. Given the current high variability of energy prices, indicators of the underlying price dynamics say more about future developments than about the overall inflation rate.
We still assume that, because of energy prices, the overall inflation rate will rise until the middle of this year – reaching our “comfort zone”. But one swallow doesn’t make a summer. For in the second half of the year, it is likely to fall again and then reach 1.5% in 2018.
So, subdued inflation will be with us for quite some time, but the spectre of deflation has disappeared from the radar of market participants.
For this recovery to gain traction, we have to keep our word. The adjustments to our asset purchase programme will be implemented as announced in December – because, first, it contributes significantly to the economic recovery and stabilisation on the price front. And second, monetary policy in times of heightened uncertainty must be a guarantor of stability and reliability by being credible.
And yet, at the same time, how much longer can we continue to talk about “even lower rates” as being a monetary policy option? Considering the importance of credibility for a central bank, as mentioned, there should be no delay in making the necessary gradual adjustments to our communication.
But support from the political dimension is needed too. Structural reforms are required in various areas as well as fiscal stimulus where budgetary flexibility exists.
And what sounded like a platitude yesterday risks being forgotten today: political stability, the rule of law and reliability are essential conditions for maintaining our prosperity. And only open markets and free trade make it possible to boost this prosperity. We need to make the cake bigger, instead of squabbling over the existing portions. Protectionism will only lead to a loss of prosperity for all.
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