The analytics of the monetary policy tightening cycle

Guest lecture by Philip R. Lane, Member of the Executive Board of the ECB, at Stanford Graduate School of Business

Stanford, 2 May 2024

Introduction

My aim today is to review the ECB’s monetary policy tightening cycle.^[1] The tightening began in December 2021 with the announcement of the end date for our net purchases under the pandemic emergency purchase programme (PEPP), as well as the recalibration and subsequent phase-out of our targeted lending programme. After concluding net purchases under the PEPP in March 2022 and net purchases under the asset purchase programme (APP) in June 2022, we subsequently normalised our policy rate (the deposit facility rate [DFR] in conditions of abundant excess liquidity) from -0.5 per cent to 2 per cent in the second half of 2022, before raising rates further into restrictive territory during the first nine months of 2023 to a level of 4.0 per cent. We have held the DFR constant at this level over the last five meetings since our last hike in September (Chart 1).^[2]

This was an especially striking tightening campaign in view of the prevailing highly-accommodative monetary stance, which consisted of very low levels of the policy rate that had been in place over the last decade, the considerable net asset purchasing under the APP since 2015 and under the PEPP since 2020 and the scale and pricing of the targeted long-term refinancing operations. In late 2021, this stance was still expected to be maintained over the medium term: for instance, the median respondent in the December 2021 Survey of Monetary Analysts expected the deposit facility rate to remain in negative territory until the first quarter of 2025 and net purchases under the APP to continue until June 2023. It follows that, relative the path expected in late 2021, the tightening cycle constituted a major surprise. Of course, the underlying driving force for the tightening cycle was the very large surprise increase in inflation, especially in 2022, after the unjustified Russian invasion of Ukraine. A defining feature is that a significant component of the stance tightening is expected to be persistent in nature, with rates only expected to descend to the neighbourhood of a more neutral level, while quantitative easing and targeted refinancing operations are not expected to be resumed.

Third, the calibration needed to allow for various types of uncertainty. Along one dimension, there was uncertainty about the intrinsic persistence of the inflation process. In addition to the standard uncertainty about the feedback dynamics by which price increases in one period would trigger subsequent price and wage increases in following periods, the scale of inflation during 2022 also led to shifts in behaviour, with firms switching to more frequent pricing resets. While this added to the intensity of inflation, it also held out the possibility that the overall adjustment process could be front-loaded.^[3] Ultimately, the persistence of inflation would turn on the scale of de-anchoring of inflation expectations, which warranted close monitoring.

Along a second dimension, there was uncertainty about the strength of transmission of monetary policy in view of possible shifts in the economic, financial and monetary environment. First and foremost, the many years of low inflation and the strategic commitment by central banks to deliver the inflation target over the medium term provided a strong foundation for containing the inflation shock, compared to the costly de-anchoring dynamics observed in the 1970s. Compared to previous tightening cycles, it was also important to take into account trend shifts in: the sectoral composition of activity (which, among other things, can affect the overall degree of price rigidity in the economy, the interest sensitivity of demand and the overall sensitivity of activity levels to domestic demand); the state of the labour market; the scale of leverage among households and firms; the state of the banking system (which had been stabilised following regulatory reforms and intensified supervision with the introduction of the Single Supervisory Mechanism) in relation to capital levels, the risk profiles of loan books (including due to the beneficial impact of borrower-based macroprudential measures) and bond holdings, together with the risk profile of liability structures; and, finally, structural exposures to interest rate movements (with a substantial increase in the share of fixed-rate mortgages).^[4]

In addition to trend shifts, the pandemic itself had resulted in lower leverage and more robust balance sheets, due to forced savings during the pandemic and the scale of fiscal transfers to households and firms. Furthermore, monetary tightening could be taking hold at the same time as a projected rebound in economic activity might protect employment levels, with firms holding onto workers in anticipation of post-pandemic normalisation. Working in the opposite direction, Russia’s unjustified war against Ukraine had triggered a major increase in economic uncertainty, while the surge in imported energy prices constituted a major terms of trade shock that substantially reduced real incomes and purchasing power: these forces were independently likely to dampen consumption and investment for any given level of monetary restriction.

Along a third dimension, the nature of the monetary configuration also created uncertainty about the tightening process. After many years of expanding the central bank balance sheet (which had further accelerated during the pandemic), the required shift in the monetary stance called for an exit from net asset purchases and a pull back from the longer-term refinancing operations that had pumped liquidity into the banking system, in addition to the lifting of the policy rate. In the absence of historical benchmarks for this exit process, there was a wide range of views about the possible impact on the financial system. In addition, since both balance sheet normalisation and the lifting of policy rates were simultaneously proceeding at a global level, there was also uncertainty about the strength of international spillovers in the tightening process.^[5]

A final uncertainty dimension related to the modelling of monetary policy. The ECB maintains a suite of macroeconomic models in order to provide robust underpinnings for forecasting and policy analysis.^[6] The projected impact of shifts in monetary policy varies across these models, in line with differences in the specification of the economic and financial environment and, crucially, in the sensitivity of inflation expectations to policy actions.

Taken together, these various types of uncertainty underlined the importance of taking a data-dependent approach to the calibration of monetary policy that would take into account the evolving inflation outlook, the realised path for underlying inflation indicators and the incoming evidence on the strength of monetary policy transmission.

I will now provide an analytical review of the transmission of monetary policy tightening to: the financial and banking systems; the economy; and, finally, inflation. I will also briefly draw some lessons from the tightening period for the conduct of monetary policy during the next phase of the cycle.

Transmission to financial markets and the banking sector

Our policy rate hikes and the phasing out of asset purchases have been passed smoothly to money markets, risk-free rates, risk assets and lending rates by banks.^[7]

Transmission via market interest rates

The money market is the immediate locus in the transmission of monetary policy. Our key ECB interest rates have a direct impact on the rates prevailing in that market, while our balance sheet policies also play an important role. The transmission of the steep increase in our policy rates to unsecured money market rates has been smooth and complete. This is essential for a proper transmission as the euro short-term rate (€STR) and expectations about its future path form the basis of the entire euro area risk-free rate curve: the overnight index swap (OIS) rates. In the secured money market, rates saw some imperfect pass-through in late 2022 as the revaluation of bonds contributed to a temporary scarcity of collateral. Our measures (such as securities lending, cash collateral, and changed remuneration of government deposits) have helped to successfully restore full transmission in that part of the money market as well.

As we returned to our policy rates as the primary instruments for steering the monetary policy stance in 2022, the understanding in the market of how we decide the key ECB interest rates has become pivotal again. This understanding contributes to the formation of expectations of market participants about the future path of interest rates and thereby has an immediate impact on medium- to longer-term interest rates, which are particularly consequential for the economy. ECB staff analysis of euro area risk-free rates and inflation-linked swap (ILS) rates suggests that financial markets have rapidly internalised the ECB’s pattern of reaction to changes in the inflation outlook. As a result, the gradual upward shift of the €STR forward curve throughout the tightening cycle (Chart 1) was more than proportional to the upward shift in market-based measures of inflation compensation (Chart 2), bringing real interest rates in the euro area from deeply negative to firmly positive levels.

Chart 2: Inflation path and fixings

(percentages per annum)

The continued anchoring of inflation expectations also helps explain another pattern in euro risk-free rates that has caused concerns among some observers: the slope of the risk-free curve – as measured by the difference between the OIS-ILS spread at a ten-year compared to two-year maturity – has been negative for over a year now and even stood at -0.8 in June 2023, a record-low level since the launch of the euro (Chart 3). Historically in the euro area and elsewhere, an inverted yield curve has often preceded economic recessions.^[8] While the euro area economy has been stagnating, fears of a deep and long recession have proven unfounded. At the current juncture, the negative slope of the yield curve points to an assessment by markets which is directionally in line with ours: short-term interest rates stand at high and firmly restrictive levels but medium to longer-term rates are lower, as inflation and with it our policy rates are set to decline over time. In other words, the current inversion of the yield curve indicates expectations of an eventual normalisation of inflation towards 2 per cent and of interest rates towards more neutral levels.

Chart 3: Slope of the risk-free yield curves

(percentages per annum)

Chart 4: Impact of APP and PEPP sovereign bonds holdings on sovereign risk premia of the big-4

(basis points)

Chart 5: Ten-year sovereign yield spreads over OIS rates

(percentages per annum)

Finally, the exchange rate response has been relatively muted over the tightening cycle. The euro has remained broadly stable against the US dollar(Chart 6). This is largely due to the considerable degree of synchronicity of the tightening cycle.

Chart 6: USD/EUR exchange rate and EA-US 2-year interest rate differential (based on OIS rates)

(left-hand scale: USD/EUR, right-hand scale: percentage points)

Transmission via the banking sector

The transmission of the restrictive monetary policy stance to bank lending conditions has evolved over the course of the tightening cycle. In general, the cost of funding for banks depends both on their sources of funding and the term structure of interest rates. Bank bond yields responded quickly to the tightening monetary policy (Chart 7). And while the pass-through from our policy rates to the average rates that banks apply to deposits has been partial and relatively slow, time deposit rates, especially those of firms, have tracked policy rate hikes rather closely (Chart 8).

One contributor to the asymmetry in the response of returns on different segments of bank funding to monetary policy was that banks had been reluctant to pass on negative interest rates to their retail depositors during the highly accommodative phase, driving a negative spread between the remuneration of customer deposits and the interest banks were receiving on reserves. As a corollary, banks were initially slow to raise deposit rates in order to restore traditional margins. In addition, the high amount of central bank liquidity and the low demand for credit also limited the pressure to increase deposit rates. Furthermore, a lack of competition in some member countries also reduced the pass through to deposit rates.

Over the period since September 2023 in which we have held our policy rates constant, bank bond yields have declined somewhat, in part reflecting the anticipation of future rate cuts, while deposit rates have continued to increase, as competition for deposits intensifies and depositors shift funds from lower remuneration overnight deposits towards more attractive time deposits.

Chart 7: Bank funding costs

(percentages per annum)

Chart 8: Deposit rates

(percentages per annum)

Banks have passed on their increased funding costs to firms and, to a slightly lesser extent, households in mortgage lending (Chart 9). Interest rates on new lending increased rapidly, peaking soon after the last rate hike in September 2023, but have been edging down recently. However, average lending rates on the outstanding stock of loans have continued to increase. This reflects the ongoing transmission of past rate hikes, as loans that were granted in the past at lower rates reprice.

Chart 9: Bank lending rates to households and firms

(percentages per annum)

The annual growth rate of lending to firms and households declined sharply over the tightening cycle but is now also showing signs of stabilisation, albeit at low levels. According to the most recent bank lending survey (BLS), net demand for new bank loans by firms is still declining, as the high interest rate environment keeps external financing costs elevated and the weak growth environment means that firms are postponing fixed investment plans (Chart 10). At the same time, banks reported a modest net tightening of bank credit standards for loans to firms, mainly on account of increased risk perception (Chart 11)

Evidence from the survey on the access to finance of enterprises (SAFE) is consistent with the weakness in bank lending to firms (Chart 12 and Chart 13). Firms participating in SAFE have reported a continued deterioration in bank loan availability, although this has eased from previous rounds and firms do expect a small improvement in credit supply over the next three months. There has also been a sharp drop in the share of firms applying for a bank loan, a continuation of the trend that began late last year. At the same time, firms signalled less reliance on bank loans, which might reflect sufficient internal funds and/or easier access to non-bank external funding, together with the postponement of investment plans due to a slowing economy or expectations of lower interest rates later this year.

Turning to lending conditions to households, the BLS results point to tentative stabilisation in net demand for new loans to households, while credit standards on household mortgages eased for the first time in two years (Chart 14 and Chart 15). Taken together, the information from these surveys is consistent with persistently-weak credit demand and stabilisation in credit supply conditions to firms and households at tight levels.

In comparison to previous hiking cycles, the flow of credit to firms has declined more quickly since the start of our policy rate hikes (Chart 16). The decline in credit observed so far in the current cycle has been stronger than historical regularities would suggest, based on linear models. The particularly large and rapid increase in policy rates may have amplified the tightening impulse. This may have activated two specific amplification channels operating through bank and firm balance sheets. The first is a risk-taking channel, in which large policy rate hikes increase the riskiness of borrowers, reducing the capacity and willingness to lend.^[9] The second is a signalling channel, through which rapid rate hikes might foreshadow a deterioration in future economic conditions, reducing the expected revenues and increasing the expected future funding costs of potential borrowers, leading them to reduce their demand for credit. Staff estimates suggest that the actual contraction in credit has been more in line with a path that incorporates such non-linear effects in transmission operating through bank and firm balance sheets (Chart 17).

The availability of liquidity to the banking system is also playing a role in the transmission to bank lending. Estimates by ECB staff suggest that banks with lower excess liquidity are more likely to reduce their supply of credit in response to policy rate hikes, and the increase in their lending rates is likely to be larger (Chart 18). This means that, as aggregate liquidity shrinks, the transmission of our restrictive monetary policy stance to bank lending may strengthen.

Finally, institutional factors, such as banking supervision and macroprudential policies, play a significant role in shaping the risk-taking behaviour of banks. Both supranational and centralised bank supervision can reduce unwarranted risk taking by banks, while encouraging lending to better performing firms.^[10] Sound macroprudential policies can also complement monetary policy by increasing the resilience of the financial system.^[11] Such frameworks, which have been put in place over the past decade, have strengthened the banking sector, and allow for a more orderly transmission of monetary policy, thus reinforcing monetary policy’s ability to fulfil its mandate of ensuring price stability.^[12]