Belgium : Ensuring price stability.
The cyclical recovery of the euro area economy is becoming increasingly solid and downside risks to the growth outlook have further diminished. 1 Today the configuration of risks around the most likely growth outlook is closer to balance than it has been in some time. Yet, downside risks still prevail, being mainly related to remaining fragilities in the global outlook. Also, despite the cyclical recovery, underlying price pressures remain subdued as unutilised resources continue to weigh on domestic wage and price formation. As yet the evidence continues to indicate insufficient progress towards a sustained adjustment in the path of inflation towards levels below, but close to, 2% over the medium term, which is a condition we have indicated for the ECB to start a gradual process of normalisation in its monetary policy stance. In view of this evidence, the Governing Council in its April meeting has judged that the complex set of instruments that we have put in place over the past three years to counter downside risks to price stability, including our forward guidance, is still needed to support a durable and self-sustaining inflation convergence. After a prolonged period of exceptional monetary policy accommodation, any change in our policy stance should be gradual. It should be motivated by sufficient evidence that the present indications of an acceleration in activity find confirmation in hard data and that a more robust growth feeds through into a sustainable adjustment in the path of inflation.
What are the conditions that led to the adoption of this complex package of monetary policy measures? And how can we measure their success in fostering progress in our economy, as a pre-condition for a lasting return of inflation to levels more consistent with our objective of price stability over a medium term horizon? Let me first lay out the strategy that we followed over the past challenging years since the collapse of Lehman in 2008 to counter a deeper and more damaging economic contraction and ward off risks of deflation and of a prolonged period of below-norm inflation. What I will refer to as the three phases of the crisis have called for the deployment of different policy instruments, so I will start establishing a correspondence between the chronology of the crisis and the taxonomy of our instruments. 2 I will then turn to the current state of the economy to extract inferences about the effectiveness of our strategy. I will then conclude looking forward.
Monetary policy responses to the crisis
In the euro area, the crisis has evolved through three phases. The first phase was triggered by the abrupt liquidity strains that almost paralysed the global financial system in the immediate aftermaths of the collapse of Lehman Brothers. Banks both in the euro area and elsewhere suddenly became very uncertain about the underlying health of other banks and stopped lending to each other. The ECB was very swift in its response, faithful to its responsibility to guarantee appropriate liquidity conditions to solvent banks. Together with other major central banks, the ECB stepped in with forceful and coordinated interventions to provide essential liquidity to the banking sector. In the euro area, liquidity was made available in virtually unlimited amounts against eligible collateral and at increasingly longer tenors, which helped those banks that were being negated access to market refinancing to remain in business and continue their key intermediation function. Without this response, the financial system would have imploded and a far deeper contraction would have occurred.
The second phase of the crisis came as a consequence of the loss of confidence in some sovereigns. It brought on the development of redenomination risk and thereby threatened the integrity of our currency. The sovereign debt crisis found impulse in some cases from a weak fiscal position, whereas in others from a weak banking system. But irrespective of its initial impulse it quickly became a two-way interaction through the bank-sovereign nexus. Banks remained dependent on fiscal authorities for solvency assistance, and the financial obligations vis--vis banks that this responsibility created on the side of some national fiscal authorities with weak fundamentals further undermined their credit standing. As the cost of borrowing for certain governments increased, banks with exposures to this debt came under intense market pressure, ultimately leading to entire national banking systems losing market access. This in turn resulted in financial fragmentation and a serious disruption to the monetary transmission mechanism. The ECB had not remained inactive in the face of such vicious feed-back loop, as it saw the implications that such dynamics could have for price stability. But, as the ECB lowered interest rates, these reductions were not being passed on to firms and households in a large part of the euro area, signalling an unusual disconnect between expanding central bank liquidity, exceptionally stimulative monetary policy interest rates and contractionary loan dynamics to NFCs and households.
The ECB then responded to these unprecedented conditions with a twofold reaction.
First, the ECB revived the longer-term refinancing instrument that had proven particularly effective in the aftermaths of the Lehman demise. Central bank liquidity was made available to banks for up to three years. This eased the pressure particularly on banks located in the jurisdictions that had been hit by the sovereign debt crisis.
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