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Monetary policy in the euro area during the crisis and after Salvatore Rossi Banca d’Italia Managing Director Research, Economics, International Relations

Capital Markets in the Post-Crisis Environment Rome, April 7, 2011 1


Timeline

• August 2007

→ Turbulence starts

• Sept/Oct 2008

→ Financial crisis intensifies

(Lehman)

• December 2009 → Exit (phasing out) begins • May 2010

→ Sovereign debt crisis

2


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

3


The money market spread (Euribor-Eurepo, 3-month) 2,0 1,8

15 September 2008 1,6

9 August 2007 1,4 1,2

financial crisis bursts

3 December 2009

7 May 2010

phasing out starts

sovereign crisis starts

turbulence starts

1,0 0,8 0,6 0,4 0,2 0,0 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

4 Source: ECB

Jul-10

Oct-10 Jan-11


Phase 2 (from September 2008 to December 2009): the crisis intensifies • 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 5


Banks’ assessment of market liquidity conditions in the unsecured segment 100%

80%

60%

40%

20%

0% 2002

2003

2004

2005

2006

2007

2008

2009

% banks saying liquidity has not changed or improved % banks saying liquidity has worsened

6 Source: ECB Money market survey, 2010

2010


The ECB official rates 6 EONIA Main refinancing rate/minimum bid rate 5

Deposit rate Marginal lending rate

4

3

2

1

0 Jan- Apr07 07

Jul07

Oct07

Jan08

Apr08

Jul08

Oct08

Jan- Apr09 09

Jul09

Oct09

Jan- Apr10 10

7 Source: ECB

Jul10

Oct10

Jan- Apr11 11


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

2

1

0

-1 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

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 8 Source: ECB and Consensus Economics


The ECB’s multi-faceted response to the global crisis • 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

9


Non-standard measures (“enhanced credit support”)

 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 10


The size of central banks balance sheets (Total assets; index, January 2007 = 100) 350

300

250

200

150

European Central Bank

100

Federal Reserve 50

Bank of England

0 2007

2008

2009

2010

2011

11 Source: ECB; Fed; BoE


Phase 3 (from December 2009 onwards): exit (phasing out) begins • 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 3month operations (maintaining ‘full allotment fixed rate’ for 1-month and 1-week operations)

12


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 13


Government bond spreads w.r.t. to Bund 11.00

sovereign debt crisis starts

10.00 phasing-out starts

9.00 financial crisis bursts

8.00 7.00 6.00 5.00

turbulence starts

4.00 3.00 2.00 1.00 0.00 Jan07

Apr07

Jul07

Oct07

Jan08

Apr08

Ireland

Jul08

Oct08

Greece

Jan09

Apr09

Spain

Jul09

Oct09

Italy

Jan10

Apr10

Portugal

14 Source: Bloomberg

Jul10

Oct10

Jan11


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 15


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) 16


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” 17


Market expectations about overnight rate (Eonia) 2,00 02/03/11

30/03/11

1,75 1,50 1,25 1,00 0,75 0,50 0,25 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12

Month in which the maintainance period begins

18 Source: Bloomberg


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

19


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 (*)

20


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

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