The road to recovery and the role of central banks Speech by Madis Müller, Governor of Eesti Pank, at the CFA Society Finland virtual Forecast Dinner
Governor of Eesti Pank
Dear fellow CFA charterholders,
We have been living with the economic crisis caused by the Covid-19 pandemic for more than a year now and so I was asked to talk about the possible road to recovery and the role of the central banks in exiting the crisis. The last year has certainly been a challenging one for all of us. Rarely has a crisis as deep as this been experienced in recent history. No country in the world has been untouched by the coronavirus pandemic. Some countries may have succeeded in avoiding the worst of the healthcare crisis over the past year but all have felt the adverse economic impact.
The world economy and the outlook for it
It was hoped at the start of the year that the arrival of new vaccines would give effective and immediate help in defeating the Covid-19 pandemic. Unfortunately, problems with the availability of the vaccines and concerns about their safety appeared almost immediately. The continued spread of the virus in some countries at the start of this year has led to restrictions on activity being tightened again. This will probably push the expected uptick in growth in the global economy back to the second half of this year. The large international institutions such as the OECD and the IMF are quite optimistic in their forecasts though. The IMF estimates that the global economy will grow by 6% this year and by 4.4% in 2022, reflecting additional fiscal support in several large economies, the anticipated vaccine-backed recovery in the second half of 2021, and the continued adaptation of businesses to the restrictions that the coronavirus has provoked. Great uncertainty surrounds this outlook, as it is still unknown the path the pandemic will ultimately take, how effective policy support will be in providing a bridge to a vaccine-powered return to normal, and how financial conditions will evolve. The economic recovery is divergent across countries and sectors, reflecting variation in the disruption caused by the pandemic and the extent of policy support. At the same time, the US and Japan and many other developed nations have approved quite generous stimulus packages to support their economies, and this should encourage growth in the global economy as well.
We saw already towards the end of 2020 that as restrictions imposed because of the pandemic were removed, the global economy recovered faster than had been expected in the middle of the year. Growth in international trade has already recovered strongly from its deep fall last year. This is also partly because the impact of the restrictions fell hardest in the service sector, which is less oriented to international trade. The purchasing managers’ composite index shows that global industrial activity continued to improve in February and March this year as demand strengthened and new orders keep coming in at a steady rate. The decline in global investment will probably bottom out in 2021 and the real recovery will start towards the end of the year with support from favourable financing conditions and large-scale packages of fiscal and monetary assistance. At the same time, the extraordinary fiscal stimulus we have recently seen in some countries combined with higher energy prices have reignited the discussion about higher inflation. I believe it is likely that the increase in inflation will be short-lived, as it is mostly driven by the base effects of energy prices and the temporary nature of the stimulus. However, it is possible that this temporary rise in inflation will affect the inflation expectations of consumers and businesses, as we know that these tend to be guided very much by recent actual inflation readings.
The euro area economy
The new waves and mutations of Covid-19 have prevented the restrictions on movement and activity being lifted in the euro area as much as was still hoped at the start of the year. Rather the opposite, as several euro area countries have in fact maintained and even tightened their restrictions. Vaccination has also been rolled out more slowly in the euro area than was expected, partly because of shortages of vaccines. As a result, the economy of the euro area has by now visibly split in two, as the industrial sector is in a relatively strong position while the service sector has been weakened again by the restrictions on activity introduced to restrain the coronavirus. Activity in the industrial sector in the euro area as a whole and separately in the largest economies of the euro area has been expanding for several months now and is at its highest level for many years. The industrial sector is primarily supported at the moment by strong foreign demand. The activity index of the services sector has remained subdued largely because of the strict limits on movement. Nevertheless, it has started to show signs of recovery recently, as hopes of progress with vaccination campaigns and the gradual relaxation of containment measures that is envisaged underpin expectations of a strong rebound in economic activity and domestic demand in the course of 2021. Business optimism has also strengthened this year, indicating that the economy has weathered the most recent lockdowns far better this time than many had expected, and than it did in the first months of the pandemic last spring.
The European Central Bank published its latest economic forecast last month, which showed that although growth has been slower at the beginning of this year than was forecast in December, we still expect growth of 4% in the economy for the year overall. We will still not get back to where we were before the pandemic though, as the economy in the euro area shrank by 6.6% over the past year. Inflation has picked up globally and in the euro area in recent months as the oil price and prices of some commodities have risen. Several temporary factors like VAT changes in Germany have also had an impact in the euro area. Various one-off factors make it probable that we will see inflation temporarily approach 2% in the second half of the year. For these reasons the European Central Bank raised its inflation forecast for this year from 1% to 1.5%. Given the continuing weakness in demand, the slow growth in wages and the large amount of economic resources standing idle though, we do not yet see any consistent inflation pressures building up.
Inflation in the euro area has averaged 1.2% over the past decade. This is some way below the target of the European Central Bank of close to, but below, 2%. It is far enough away from the danger of deflation but still low enough to encourage growth in the economy. To get closer to the target, we have introduced several extraordinary monetary policy measures such as negative interest rates, longer-term targeted loans and asset purchases. Inflation will however remain below the target of the central bank throughout the forecast horizon up to 2023.
Euro area governments have provided wage subsidies and loan guarantees during the crisis, and this has proved of great assistance to firms and households. Such support measures are necessary for as long as restrictions remain that prevent the economy from functioning normally. Government loans and guarantees or capital injections have contributed to alleviating liquidity constraints, and have helped businesses in sectors where problems have been acute. Furthermore, supervisory and macroprudential policies have freed up bank capital to absorb losses and to support the flow of credit to the non-financial economy. The supportive monetary policy will help maintain favourable financing conditions throughout the forecast horizon.
The support packages have however increased the debt burdens of national governments, and pushed them very high in some countries. The autumn forecast of the European Commission saw the debt burden in the euro area rise to as much as 102% of GDP last year. The sustainability of the debt is currently not a problem given the low interest rates, but borrowers should be prepared for a rise in interest rates in the longer term. To be able to service that debt in the future, it is very important to invest now in areas that will lay the foundations for new growth. It is good to note that there is a common understanding about setting the priorities for recovery financing within the European Union.
Central banks and their role in the crisis
The Covid-19 crisis has put the ability of central banks to react quickly enough to the test. We have indeed reacted, and that can be seen from the balance sheets of the central banks. The swift and massive monetary policy support was almost instant this time. The initial aim last spring was to calm the markets and inject enough liquidity into the financial system, but this was soon followed by credit support policies, which were also rolled out very quickly. In many instances the fiscal and monetary authorities worked hand in hand, with the former providing guarantees and the latter providing financing. This meant it was also possible for the Federal Reserve to start purchasing corporate bonds and commercial paper and to create other loan facilities that would not have been possible without such cooperation. Another notable feature was the willingness of the central banks to provide swap lines and repo facilities to other central banks. As a result we see the most remarkable synchronicity in the growth in the balance sheets of the major central banks.
At some point the healthcare crisis will recede. Unlike financial crises, which tend to weigh on demand for a long time, the crisis induced by the pandemic might be followed by a rapid revival once the restrictions are lifted. We cannot of course know for sure the extent of the scarring on businesses that the crisis will leave behind and we need to recognise that there is still a lot of uncertainty about how quickly the virus can be contained. While a few central banks have already started to talk about exit plans, it is clearly too early for that in a majority of countries. Indeed, most central banks in advanced economies are still signalling that monetary policy support will continue through policy rates remaining low, while asset purchases and an abundant credit supply with attractive interest rates are maintained. The considerable amount of slack in the economy will prevent persistently higher price pressures from emerging yet.
Let me now discuss a few points about monetary policy in the euro area. When the Covid-19 crisis hit, the Eurosystem responded rapidly as it initiated new monetary policy measures while also recalibrating its existing ones.
- The measure that has seen the most prominent public discussion has been the pandemic emergency purchase programme (PEPP). The PEPP was introduced in March with an envelope of €750 billion, which was increased twice over the year. It was decided last December that its total envelope could now amount to €1850 billion. There is a lot of flexibility in the PEPP and it could be recalibrated again if the pandemic causes further shocks. At the same time, the full envelope of the PEPP does not have to be used if favourable financing conditions can be maintained with a lower volume of asset purchases. In December the Governing Council extended the horizon for net purchases until at least the end of March 2022.
- The PEPP was not the only enhancement though. The first decision taken, even before the PEPP was launched, was to add an extra €120 billion of purchases over 2020 to our existing asset purchase programme (APP). This was in addition to the ongoing €20 billion monthly net purchases.
- Liquidity and credit support for the banking sector and a relaxation of collateral rules were a very important element of the crisis measures. Longer-term refinancing operations were introduced with various lengths. The Governing Council also expanded the targeted longer-term refinancing operations (TLTRO-III) and made their conditions considerably more favourable. This provided banks with a large volume of long-term funds at extremely low interest rates.
- Central bank swap lines were reactivated with the Federal Reserve and other major central banks, and a repo facility was set up to provide euro liquidity to non-euro area central banks.
The policy support for the economy given by the Eurosystem was already significant even before the Covid-19 crisis erupted. The list of unconventional policy measures shows how our realm has widened over the last decade far beyond traditional interest rate policy. The ECB was the first among the major central banks to introduce negative rates on its deposit facility, and the rates have only gone lower over subsequent years. Negative lending rates on long-term loans to the banking sector, as applied by the ECB, are even rarer at central banks. On top of this we have bought public and private sector assets under numerous purchase programmes for years. Monetary policy has evolved a long way and it has provided crucial support to the euro area economy and helped create many jobs. But we also know of course that the ever-larger footprint of central banks in the financial markets comes with its own set of risks. We must remain conscious that many short-term stimulus measures may have long-term costs. Extensive purchases of government bonds by central banks might push bond prices too far from their fundamentals, while the same can happen with other assets if interest rates remain at very low levels for a long time. This is why we always conduct a proportionality analysis of different monetary policy alternatives before taking decisions at the Governing Council of the ECB. Given the current, still weakened, state of the euro area economy, it is too early to discuss any exit strategies from the current policies.
The crisis response and the previous accommodation can be seen in our balance sheet. The Eurosystem’s holdings of securities for monetary policy purposes currently stand at almost 4 trillion euros, which is roughly 35% of the euro area GDP in 2020. Meanwhile, around 2 trillion euros have been injected into the banking system under the long-term refinancing operations and so the total Eurosystem balance sheet has expanded to over 60% of GDP, which is proportionally much more than the balance sheet of the Federal Reserve for example.
Once the pandemic crisis has receded and the economy is running in a faster gear again, there will come a time when the emergency measures will be phased out. However, there should be no worries about a cliff-edge effect, as monetary policy will not suddenly become restrictive. It has been clearly communicated by the Governing Council of the ECB that the policy will remain accommodative until we see inflation converging more clearly towards our inflation target. As it will take time for the economy to recover from the pandemic, the Governing Council of the ECB has promised to focus particular attention on keeping the financing conditions favourable in the euro area for as long as the crisis lasts. It is important to highlight that a broader view must be taken when considering what favourable financing conditions really mean. The ECB is not targeting any specific nominal or real level of bond yields, as the appropriate level for rates will change as economic conditions and the outlook change.
It is clear though that low interest rates by themselves will not bring us out of this crisis. The favourable funding needs to find its way to new projects launched by businesses, and governments should invest the money they borrow in reforms and in laying the grounds for future growth. In conclusion, if everybody plays their part, we will be successful in combating the current crisis and in raising the potential for growth in the euro area economy, and we will end up on a path of more resilient development.
Thank you for your attention and for allowing me to share my views on this topic.