Credit market developments may limit ECB actions on interest rates

‘Some of the risks of the 2008-12 period could resurface’

Ignazio Angeloni, a former member of the European Central Bank’s supervisory board, is one of Europe’s most seasoned central bankers, with ample experience of covering twin responsibilities in monetary and financial stability. This is an edited extract of Angeloni’s conversation with David Marsh, OMFIF chairman, at the DZ BANK-OMFIF capital market conference in Frankfurt.

Angeloni thinks that the ECB should not have relaunched expansionary policies just before the Covid-19 outbreak and should not have prolonged quantitative easing for so long in 2021 and in the first half of 2022. But he says: ‘These bygones are not very important from today’s perspective. The interest stance the ECB has taken since last July is correct.’

Given worries about financial stability, Angeloni cautions the ECB to go carefully with further interest rate increases – echoing comments by Ignazio Visco, governor of Banca d’Italia. Angeloni said: ‘To the extent that banks tighten credit, slower or lower ECB tightening action may be needed as we move on.’ In view of a likely period of low growth and relatively high inflation, Angeloni warns: ‘Some of the risks of the 2008-12 period could resurface’.


‘The banks face two unhappy alternatives’


David Marsh: There have been squalls with banks in both the US and Europe in the last two months, partly reflecting the difficulties of coping with higher interest rates. We remember the early years of the 2000s, when supervisory and regulators allowed too much risk to build up in the banking system. How close are we to a return of these difficulties of 2007-09 – in both Europe and the US?

Ignazio Angeloni: There are both commonalities and differences between the US and Europe, as far as banks are concerned. The main commonality is that banks reacted to the lower-for-long period of interest rates in a similar (and predictable) way by increasing exposures to long-dated bonds, and also increasing mortgage exposures, mainly at fixed rates but also at floating rates.

DM: What are the effects as interest rates rise?

IA: The banks face two unhappy alternatives. They either hold on to their assets and haemorrhage gradually through their profit and loss accounts. Or they sell the assets and face losses all at once. To the extent that mortgages were arranged at floating rates, the losses fall on households, with a possible strong contractionary effect on consumption.

DM: What about deposit movements?

IA: That’s another commonality. Evidence is mounting that the velocity of deposit runs has increased in the US as a result of digital banking and the concentration of deposits. We still lack good analyses of this phenomenon for Europe. The speed of deposit movements may have increased here as well.


‘The US relaxed its post-crisis regulatory stance too much during the Donald Trump administration’


DM: What are the main differences?

IA: These lie in the regulatory stance. The US relaxed its post-crisis regulatory stance too much during the Donald Trump administration. The US’s strength lies in a functioning crisis management framework, centred on the Federal Deposit Insurance Corporation. The euro area has had a better supervisory stance but its weakness is in the incompleteness of the banking union and especially in the lack of a credible crisis management framework.

DM: How close are we to repeating the events of 2008?

IA: I am concerned because we do not have a good picture yet. The interest rate rises and the transmission of their effects are still playing out and could still present surprises. Hopefully, the single supervisory mechanism has good information, especially on bank exposures and related risks. In any case, the ECB from now on will have to manage the situation very cautiously and gradually.


‘The last pre-pandemic expansionary step was unnecessary’


DM: What do you think of the view of Jacques de Larosière that central banks themselves are to blame for this state of affairs through their insufficient grasp of the earlier problem of higher inflation?

IA: De Larosière’s remarks are true, but not very useful in dealing with the situation. The LFL phase is to a large extent at the root of our present problems. Had the inflation risk been spotted earlier, the interest rate rise could have been more gradual, giving the system more time to adapt.

DM: Where have mistakes been made?

IA: The last pre-pandemic expansionary step – the ECB’s decision to restart quantitative easing in September 2019 – was unnecessary. And the tightening cycle should have come in the second half of 2021, rather than in 2022. But we are where we are: we need to face the situation as it is now. These bygones are not very important from today’s perspective. The interest stance the ECB has taken since last July is correct.’


‘The ECB has moved well, but now may come the difficult part’


DM: What should happen next? Does the ECB decision on 4 May to raise interest rates by a relatively moderate 0.25 points and stop all asset purchase programme reinvestments from 1 July go far enough?

IA: After some initial hesitation, the ECB has moved well, but now may come the difficult part: understanding how the transmission through banks is playing out. The interest rate stance is still expansionary, as measured by the short-term interest rates net of short-term inflation. But the impact on banks is a big unknown.

DM: You have suggested a means of drawing liquidity through reverse targeted long-term refinancing operations.

IA: Yes, a new reverse long-term operation providing commercial banks with the rights to swap central bank deposits for long-term securities, allowing a gradual lowering of the deposit rate. Bank liquidity buffers are declining already, but a repurchase instrument would accelerate the process and make it more flexible.

DM: How close are we to seeing action to improve matters?

IA: The ECB has three levers to move: interest rate increases, quantitative tightening and liquidity absorption, and action on the deposit rate. To the extent that banks tighten credit, slower or lower ECB tightening action will be needed.


Operating two sets of policies is not a choice, but an obligation


DM: Are worries over financial stability likely to prevent central banks from taking tough measures to reduce inflation? There are surely trade-offs – whatever the official doctrine of the ECB? Can central banks operate two sets of policies at once to safeguard both monetary and financial stability?

IA: The ECB has been, since 2014, responsible for both price stability and financial stability. So operating two sets of policies is not a choice, but an obligation. The question is: are the instruments for these policies separate or to some extent related? My short answer is that these instruments must stay separate in calm times but need to come together and reinforce each other in a crisis.

DM: Are there lessons you can draw from the UK’s autumn 2022 fiscal-monetary episode over the Liz Truss – Kwasi Kwarteng budget?

IA: The main lesson from the UK episode is that governments can help the action of central banks, or they can hinder it.

DM: What implications does this have for the transmission protection instrument – where you have famously called for a ‘user manual’? There isn’t one yet!

IA: In the euro area, governments can help by reducing the probability of ‘doom loops’ between government finances and bank instability. Concretely this requires keeping government finances under control and ensuring that banks are sound. The main problem in the euro area is the imperfect banking union. But member states also have work to do: strengthen their banks and reinforce the parts of the banking frameworks for which national authorities are responsible.


‘The distinction in the EU treaty between bond purchases at issue and on the secondary market is a tenuous one’


DM: The European treaties say that the ECB must not get into the business of financing governments. How do you react to criticism that QE protects governments from the discipline of sound fiscal policies? There has been an arithmetical correlation in recent years between net issuance by euro area government and net ECB bond purchases. Is this another reason why did the ECB’s QE went on for too long? 

IA: Indeed, the distinction in the EU treaty between bond purchases at issue and on the secondary market is a tenuous one. Especially when purchases are massive and long-lasting, as they have been, buying on the secondary market helps the primary market as well, because auction participants know that they will be able to re-sell the bonds they purchase at issue, so they are encouraged to buy.

DM: Can this problem be avoided?

IA: Any central bank must intervene in bond markets. They have to be independent in doing so. Ultimately it is up to them and their judgement.


‘It will be difficult to bring inflation back to 2% on a stable basis’


DM: Given central banks’ difficulties controlling inflation, particularly after the outbreak of the war in Ukraine, it seems likely to me that inflation in the euro area will settle in the area of 3% to 4% for some years because it will be highly difficult (and painful) to get it down to 2%. That need not be a tragedy. It will help to reduce the debt burden for the most indebted nations. So how likely is this scenario?

IA: I agree that in the euro area it will be difficult to bring inflation back to 2% on a stable basis. Most factors that facilitated that outcome in the years of the ‘great moderation’ are now gone. Economists were debating then whether that outcome was the result of ‘good policies’ or ‘good luck’. Now we know that it was the second.

DM: So what does the future hold?

IA: My main concern is that the euro area may be entering a phase of stagflation, owing to a combination of three factors. Private expenditure is stalling as a result of uncertainty and risk aversion. Public expenditure is not sufficiently supportive because of an inability to implement the recovery and resilience investment plans in full under the Next Generation EU programme. And monetary policy is stuck in a bad equilibrium with high inflation.

DM: What is your conclusion?

IA: In that scenario, some of the risks of the 2008-12 period could resurface.

Angeloni is a part-time professor at the Robert Schuman Center of the European University Institute in Florence and a senior policy fellow with the Leibniz Institute for Financial Research SAFE at the Goethe University Frankfurt. He is a former member of the ECB’s supervisory board and head of the ECB’s financial stability and macroprudential policy department. He coordinated preparations for the ECB’s single supervisory mechanism. Previously he worked at Italy’s finance ministry, Banca d’Italia and the International Monetary Fund.

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