–Expanding Sov Debt Crisis Must Be Halted To Avoid Macro, Fin Disaster

NEW YORK(MNI) – Following is the second part of the text of a
speech by European Central Bank Executive Board member Juergen Stark
Friday at the Forecaster Club of New York:

Monetary policy

The ECB from the very beginning of the crisis has taken decisive
and swift action through both its standard and non-standard monetary
policy measures. In a first response to intensified financial market
tensions, and based on our assessment of medium-term risks to price
stability in the euro area, we reduced our key interest rates by 325
basis points between October 2008 and May 2009 and kept them unchanged
until April 2011. During this time, the main refinancing rate of the
Eurosystem stood at 1%. [SLIDE 6]. Over the same period, the overnight
money market interest rate (EONIA) also decreased rapidly, reaching
levels as low as 0.3%.

Earlier this year, in April and July, we raised interest rates in
two steps, each time by 25 basis points. At that time, we were concerned
that prevailing upward price pressures, mainly from energy and commodity
prices, could translate into second-round effects in wage and
price-setting and to broad-based inflationary pressure. However, the
picture has changed since then. The economic outlook has worsened amidst
continued high uncertainty and intensified downside risks. In such an
environment, it is reasonable to expect moderate price, cost and wage
pressure. This assessment has led us to the decision last month to
reduce rates by 25 basis points. Our main refinancing rate therefore now
stands at 1.25%, and the rates on the deposit facility and marginal
lending facility at 0.75% and 1.75% respectively. [SLIDE 7]

At the same time, we have introduced a number of non-standard
monetary policy measures, with the aim to support credit flows from
banks and thereby ensure that our interest rate is transmitted properly
to households and firms. Notably, the design of these measures has taken
into account the pivotal role of banks in financing the real economy of
the euro area [SLIDE 8]. They focused on a proper functioning of the
banking sector, by ensuring that funding markets, notably the money
market, continued functioning. The main non-standard monetary policy
measure in that context is the full allotment of liquidity demand by
banks, at fixed, low rates, against eligible collateral.

In addition, the ECB also engaged in buying government securities
via its Securities Markets Programme (SMP). The Governing Council’s aim
of this programme is to restore a proper transmission process that
threatened to become impaired given dysfunctional market segments, as
witnessed by very high interest rate spreads on sovereign bonds [SLIDE
9]. This is a major difference with quantitative easing in other major
countries where such bond purchases are conducted in financing
governments and against the background of official interest rates being
close to the lower zero bound. The aim of quantitative easing is to have
a more accommodative monetary policy stance via lowering long-term
interest rates. By contrast, the ECB’s purchases of bonds aim to ensure
that our official short-term interest rates are transmitted in a proper
way to the economy. Another difference is that the ECB fully sterilises
the liquidity injected in the market through its SMP while this is not
the case in the US and the UK. The ECB has much less government
securities on its balance sheet than the central banks of the US and the
UK [SLIDE 10]. To be fair, this difference not only reflects the
quantitative easing policy conducted in the UK and the US. In the US,
for instance, government bonds already were an important item on the
balance sheet of the Federal Reserve before the crisis. The Federal
Reserve typically implements its monetary policy through purchases and
sales of government bonds.

Let me also emphasise that all the non-standard monetary policy
measures taken by the ECB are temporary in nature and complementary,
rather than supplementary, to our interest rate instrument.

At the same time, we should not forget the adverse side-effects of
interest rates being kept at very low levels for a long time. In fact,
the period preceding the start of the financial market tensions in
August 2007 is reminiscent of the associated risks. Notably, the very
low level of global interest rates after 2001 and the resulting ample
liquidity conditions at the global level has laid the basis for the
current crisis. In addition, maintaining very low interests rates for a
protracted period may weaken the financial incentive for deleveraging
for both the banking and non-financial sectors, and can result in
“evergreening” of outstanding loans. Very low interest rates may also
discourage banks from trading in interbank money markets. This is an
important market for the transmission of monetary policy. Related, it
has adverse effects on some financial institutions such as money market
funds.

Overall, the combination of standard and non-standard monetary
policy measures has been successful in maintaining inflation rates
below, but close to, 2% over the medium term, while ensuring the
transmission of monetary policy in difficult times. This is witnessed by
fairly stable inflation expectations around ECB’s objective [SLIDE 11].
The ECB therefore has delivered fully on its mandate.

Unfortunately, that cannot be said of all policymakers involved,
resulting in the lingering of the sovereign debt crisis. To tackle the
crisis decisively first and foremost requires tackling its root cause
will require ambitious fiscal policies and structural reforms.

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