ECB’s Schnabel: Rising Real Interest Rates Don’t Imply Worse Financing Conditions

25 March 2021

By David Barwick – FRANKFURT (Econostream) – Rising real interest rates do not necessarily mean that financing conditions have become less favourable, European Central Bank Executive Board member Isabel Schnabel said on Thursday.

In a speech at an NYU Stern Fireside Chat posted to the ECB’s website, Schnabel said that markets would have a better idea of what to expect from the ECB, enhancing efficiency gains from monetary policy, if they know which developments the ECB will see as favourable, she said.

In this context, she recalled that it is real interest rates that determine the behaviour of economic agents, while nominal rates can track expected growth and inflation and are thus ‘not a good indicator of the degree of monetary policy accommodation.’

Moreover, ‘the favourability of financing conditions is a relative concept’ depending on the difference between real interest rates and real equilibrium rates at which inflation is stable, she said. ‘Monetary policy is only accommodative if actual real rates fall below these equilibrium rates’, she said.

Rising real interest rates thus do not automatically imply worsening financing conditions, she said, citing the example of economic recovery, when the former would occur hand-in-hand with an increase in the real equilibrium rate.

‘Monetary policy will not tighten in this case’, she said, as the degree of stimulus will be unchanged. ‘These considerations are what distinguishes a policy of preserving favourable financing conditions from yield curve control’, given that ‘[t]he latter targets a fixed level of nominal yields with a view to increasing, rather than preserving, the degree of monetary accommodation.’

However, rising real interest rates could ‘unduly tighten our policy stance’, she said, if for example a rising real term premium signalled ‘growing uncertainty around the monetary policy outlook or indigestion of duration supply.’ Such an increase, ‘if sizeable and persistent, make financing conditions less favourable as they are not accompanied by a corresponding increase in real equilibrium rates’, she said.

This was less of an issue recently, but the ongoing need for high public debt issuance and consequent increase in duration risk to be absorbed by markets could unduly push up the real term premium, she said.

‘A firm commitment to favourable financing conditions therefore requires a certain minimum purchase volume to offset this effect on real interest rates’, she said.

As well, real interest rates that rose because markets started to price in a strong recovery or due to global spillover effects ‘could result in vital policy support being withdrawn prematurely’, she said.

In assessing the favourability of financing conditions, the ECB must therefore focus on what is behind any changes and how fast they occur, she said. ‘[C]ross-asset price correlations’ can help understand possible changes in real interest rates, she said.

‘For example, if stock markets increase and credit spreads tighten in response to a rise in real interest rates, markets are likely to price in a stronger growth outlook that could leave financing conditions favourable’, she elaborated.

Changes in market financing conditions also have to be considered in the context of growth and inflation forecasts, she said, giving ECB staff forecasts ‘an important role’, even if the ECB retains the flexibility to adjust its asset purchases in any direction between meetings.

The ECB’s commitment to preserve favourable financing conditions represents ‘a departure from a policy that attempts to push interest rates even lower’ and also ‘shifts the focus from quantities – the amount of assets we purchase - towards prices - the conditions at which sovereigns, firms and households can access credit.’

Whereas in the initial response to the crisis ‘quantities were an end in themselves’, she said, they are now ‘a means to an end: they are used to the extent necessary to deliver on our commitment to preserve favourable financing conditions.’

Schnabel, as before, left the door open to a standard policy move, affirming that ‘since we are not yet at the effective lower bound, such actions remain possible in the future’, though she also suggested that under circumstances of high uncertainty and constrained private demand, such a move ‘would likely have limited effects.’

The preservation of favourable financing conditions ‘is a strong commitment to protect an exceptional degree of policy accommodation for as long as needed’ that ‘signals our unwavering determination to offset the impact of the pandemic on the projected inflation path’, she said.

The deployment of the purchase envelope will be guided by the goal of price stability, she said, reiterating that the envelope might not need to be exhausted but, ‘equally’, could be recalibrated if necessary.

The PEPP’s flexibility in terms of time, asset classes and jurisdictions will be exploited ‘in a way that ensures favourable financing conditions for the entire economy and paves the path to recovery’, she said.