ECB’s Schnabel: Cannot Turn a Blind Eye to Rising Financial Stability Risks

8 December 2021

By David Barwick – FRANKFURT (Econostream) – The European Central Bank’s monetary policy must take into account increasing risks to financial stability, Executive Board member Isabel Schnabel said Wednesday.

In a speech at the fifth annual conference of the European Systemic Risk Board on monetary policy and financial stability, Schnabel said that ‘monetary policy cannot turn a blind eye to rising financial stability risks.’

While emergency situations call for targeted measures by monetary authorities, when the economy is improving, she said, ‘central banks must recognise that the actions they take to deliver on their price stability mandate have the potential to contribute to a build-up of risks to financial stability.’

‘These risks have arguably increased in the vicinity of the zero lower bound’, she said, with the steady sinking of the real equilibrium interest rate making standard monetary policy tools less effective. This forces greater reliance on balance sheet policies that are riskier in terms of financial stability, she said.

The current environment is one in which ‘a strong recovery in domestic demand and a rapid erosion of economic slack are expected to gradually bring inflation back to our target in the medium term, a combination of adverse supply-side shocks, mainly related to rising energy prices and supply chain disruptions, is now pushing inflation well above our target’, she said.

‘Responding to such supply-side shocks by raising policy rates prematurely would risk choking the recovery and, given the long lags in transmission, exert downward pressure on inflation at a time when the shocks are likely to have already faded’, she said, which is why ‘supply-side shocks typically warrant a temporary deviation from the target, provided price stability is restored over the medium term and inflation expectations remain anchored.’

By the same token, when the ECB opted to preserve favourable financing conditions, it avoided the risk of lowering interest rates yet further and thus encouraging overvaluations on financial and real estate markets, she said. In doing so, it also implicitly accepted a lengthening of the medium-term horizon, she said.

‘In the future, challenges may reverse’, she said, in which case, ‘monetary policy must not be held hostage by fiscal or financial dominance – that is, even if financial markets have become more sensitive to changes in policy, central banks need to find ways to secure price stability without jeopardising financial stability.’

Policy sequencing inversion would not be ‘an appropriate policy response in such circumstances’, as ‘[m]aintaining a high volume of asset purchases merely to avoid adjustments in long-term yields in spite of imminent risks to price stability would give way to fiscal and financial dominance’, she said.

At the same time, fragmentation is a structural threat in the euro area, so that changes in the policy stance could cause unexpectedly abrupt changes in financing conditions in some countries, she said. A possible solution would be a ‘credible backstop’ like the pandemic emergency purchase programme (PEPP), she said.

The importance of preferring tools with the least risk for financial stability would argue for relying less on asset purchases now, she implied, given that ‘their cost-benefit ratio deteriorates as the economy gains ground’ in view of issues related to moral hazard, excessive risk-taking and overvaluations, and market functioning.

‘So, by gradually shifting the policy mix away from net asset purchases when the monetary policy objectives are within reach, central banks can mitigate financial stability risks effectively’, she said.

The favourable conditions of the ECB’s targeted longer-term refinancing operations (TLTROs), and the two-tier system exempting credit institutions from remunerating part of their excess reserve holdings at the negative rate currently applicable on the deposit facility, ‘broadly offset the costs banks incur when holding excess liquidity in a negative interest rate environment’, she said.

‘And both of these tools can be adapted and recalibrated should we see risks to the bank lending channel emerging’, she added.

Schnabel delivered a clear warning regarding housing markets, saying that increased vulnerabilities in them ‘warrant a timely increase in system-wide resilience. Broad-based house price rises across both urban and rural areas, as well as growing signs of overvaluation, are rendering residential real estate markets in parts of the euro area increasingly prone to correction.’

Lending to finance homebuying is nonetheless continuing apace and credit standards have deteriorated in some places, she said.

‘Owing to long transmission and implementation lags, macroprudential policy needs to be tightened today to counter the risks posed by these developments’, she urged. Borrower-based measures should be considered and possibly implemented in eight euro area member countries, she said, while in two, targeted capital measures should be considered.

However, she criticised, countries do not react with uniform promptness to relevant recommendations, and some have not done enough. In this context, she cited Germany, which ‘remains the only euro area country where no macroprudential measures are currently in place – despite indicators of house price overvaluation having increased by 15 percentage points since the outbreak of the pandemic.’