Monetary policy and financial stability

A key part of the Central Bank’s role is the maintenance of monetary and financial stability. Our work on the first of these is primarily done through monetary policy set for the euro area by the ECB’s Governing Council.  And here in Ireland we set out our views on the key risks to financial stability – and our plans to mitigate them – in our latest Financial Stability Review (FSR) last week.

In this blog, I want to highlight the interactions between the ECB’s recent monetary policy decisions and the Central Bank’s decisions aimed at ensuring financial stability for the Irish economy. The financial system transmits monetary policy to households, businesses and governments and, therefore, a well-functioning and stable financial system helps monetary policy to work better. In fact, financial stability is a pre-condition for price stability, and vice versa.

Inflation and unconventional monetary policies

The current rate of inflation is concerning.  It affects households’ purchasing power and it affects business investment decisions.  Following the review of our monetary policy strategy last year, the Governing Council confirmed that its objective was for inflation to be at 2 per cent over the medium term.  It is clearly not at that level today.

But before we explore the action that we’ve decided to take to ensure that we deliver on the 2 per cent objective, it’s worth reflecting on how monetary policy has operated over the past decade or so.  As many will know, the ECB has had to take action to counteract inflation being below target, including the use of unconventional tools such as negative interest rates, longer-term loans to banks (to encourage lending to businesses and consumers), and asset purchases.

Interest rates are the main tool that central banks use to achieve the goal of price stability (a positive but moderate increase in prices over time, 2 per cent over the medium term in the case of the ECB). Price stability matters because if prices increase too quickly (i.e., above target inflation), it’s harder to plan and you’ll be able to buy less with your income.  The opposite of inflation is deflation and while falling prices might seem attractive, deflation can have very serious effects for the economy. Consumers postpone their purchases (in the hope that prices will fall further) and businesses postpone investment, with negative implications for the economy and wider community.  If inflation is – or expected to be – above target, central banks increase interest rates which makes borrowing more expensive and saving more attractive.  As a result, consumption (spending) is reduced which ultimately leads to lower inflation rates.

The low interest rate environment in the euro area – and in advanced economies generally – is not all due to central bank actions, as interest rates in an economy are also influenced by structural factors (such as demography) which can affect the willingness of households and businesses to borrow or save.  Low rates mean that the standard monetary policy response of reducing interest rates is constrained (as rates approach zero).  In 2014 the ECB reduced interest rates marginally below zero, which was – and is – very unusual for the financial system.  Negative rates have limitations, which brings me to asset purchases.

In the low interest rate environment, asset purchases have been a key tool to bring inflation back to the target of 2 per cent over the medium term. The aim of such purchases (financial assets including government bonds, corporate bonds and other securities) was to influence financial conditions in the euro area which, when combined with negative interest rates (and longer-term refinancing operations), encouraged households and businesses to borrow and spend, so that prices did not enter a deflationary spiral.

However, unconventional measures such as asset purchases and negative rates also have an effect on financial stability. As financial conditions ease, households and businesses are incentivised to take on more risk through higher debt burdens, creating the potential for the borrowing to become unsustainable as rates normalise.  Similarly, the ‘search for yield’ becomes evident in financial markets: investors receive less from safer counterparties as financial conditions ease so instead they lend to riskier counterparties to obtain a higher yield on their investments (and achieve their targeted returns).

Monetary policymakers in the euro area have a clear primary mandate, price stability. However, interactions with financial stability are also important and, because of variation across countries, are a key domestic policy consideration.

Our recent monetary policy decisions – the road to normalisation

I will return to these interactions shortly but first the ECB’s recent monetary policy decisions which are aimed at ensuring inflation returns to our target.

We began moving away from the world of unconventional monetary policy and towards normalisation in December last year when we decided to reduce the amount of assets we purchased. We’ve continued on this road and in fact picked up the pace at our meeting nearly two weeks ago.  We decided to end net asset purchases at the end of this month and to start increasing our key interest rates from next month. We also expect to raise interest rates again when we meet in September, although by how much will depend on the evidence over the next few months.

These decisions are a clear break from the past decade or so. They will return monetary policy to a more normal footing.  But the non-standard tools remain in our toolkit, having proven useful in an environment of below-target inflation and also to ensure that monetary policy is transmitted smoothly across the euro area.

Interactions between monetary policy and financial stability

As I mentioned, monetary policy decisions impact on financial stability.  This goes both ways: financial instability can cause serious problems for the delivery of price stability. The Governing Council conducts regular assessments of the interactions between monetary policy and financial stability. 

At our most recent meeting we concluded that the environment for financial stability had worsened across the euro area: lower growth, lower real incomes due to higher inflation, and tightening financial conditions may be challenging for borrowers.  But looking beyond the short-term, tighter financing conditions could also reduce existing financial stability vulnerabilities by dampening some of the ‘search for yield’. Our FSR came to similar conclusions, although risks do of course vary from country to country across the euro area. In our view, the medium-term risks facing the financial system have increased, amplified by Russia’s war in Ukraine.

Macroprudential policies are the first line of defence in preserving financial stability and are within the Central Bank’s remit in Ireland (which isn’t always the case in other countries). Macroprudential tools include borrower-based measures (such as our mortgage measures) and bank capital measures (such as the countercyclical capital (CCyB) and systemic risk (SyRB) buffers).

A particularly important feature of macroprudential policy is it is tailored to address specific risks in an individual economy. This matters in a currency union such as the euro area where monetary policy is set for the union as a whole.

For Ireland, the key characteristics of our economy are its (relatively small) size and openness.  This means we tend to experience ‘higher highs and lower lows’ compared to larger and more diversified economies which has implications for financial stability.  Macroprudential policies, such as the mortgage measures and the CCyB, are key to build resilience in Ireland’s financial system. And the fact that this resilience is in the system means that there is less concern with respect to financial stability when it is necessary to tighten monetary policy to counter inflation above target (as the ECB’s path to normalisation is effectively doing now).  

Last week we announced that the CCyB would start to be rebuilt (having been reduced to zero from 1 per cent at the start of the pandemic). A positive CCyB requires commercial banks in Ireland to set aside additional capital which can be released as needed in a downturn and allows us to address cyclical risks as we see them building.  Ultimately, our objective is ensure a sustainable provision of credit to the economy in good times and in bad.  We have decided that the buffer will be rebuilt at a starting rate of 0.5 per cent which will increase to 1.5 per cent, depending on conditions in the economy and financial system. (And if we came to a view that risks to financial stability warranted a higher rate, we would increase it above 1.5 per cent.)

Conclusion

The Governing Council of the ECB will continue to adjust monetary policy for the euro area to ensure inflation returns to our two per cent target over the medium term.  And macroprudential authorities, such as the Central Bank of Ireland, will continue to take action to ensure the financial system remains resilient to the risks it faces, and can serve the economy in good times and in bad.

Gabriel Makhlouf

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