Today, in a speech before a conference organized by Banca d’Italia, Bruegel and the Peterson Institute for International Economics in Rome, Mr. Lorenzo Bini Smaghi, Member of the Executive Board of the European Central Bank (ECB) delivered a speech entitled “An ocean apart? Comparing transatlantic responses to the financial crisis,” The conference was organized primarily to examine "how policy authorities on both sides of the Atlantic have reacted to the [present] financial crisis."
Mr. Smaghi, in his remarks acknowledged that central banks on both sides of the Atlantic since the onset of the crisis have responded both swiftly and decisively while in many instances have coordinated policy actions. Mr. Smaghi, also noted that in addressing the crisis many central banks have adopted non-standard measures to bolster and stimulate their respective economies. However, the framework of such measures adopted reflect the intrinsic structural characteristics of those respective economies. Particularly, in case of the ECB, the non-standard measures adopted focused primarily on banks, which provide a substantial source of liquidity to the euro area economy, as opposed to the non-standard measures adopted in the United States which were more market centric.
Mr. Smaghi also addressed the importance of adopting a “well thought-out exit strategy” in order to effectively reverse the policy measures implemented to address the crisis. He stressed the importance of market actors recognizing that the current policies in place are “temporary and will be reversed when it is no longer appropriate, in particular when risks to price stability re-emerge and conditions in financial markets have improved.” Mr. Smaghi, however, emphasized that policies still had to remain in place to support continued economic recovery, but that implementing an exit strategy was “an act of responsibility for a central bank.”
Mr. Smaghi, identified some key issues within the context of an analytical framework, that will have to be addressed and considered before adopting an exit strategy on both sides of the Atlantic. Such issues include reversibility, optimal interest rate and price stability.
With respect to reversibility, undoubtedly, the timing related to implementing an exit strategy is crucial to avoiding further financial instability. Mr. Smaghi, noted that “the decision to exit is bound to have an impact on agents’ interest rate expectations throughout the whole yield curve, and lead to substantial portfolio reallocations.” Although this is a desirable effect, he cautioned that “if the adjustment in expectations is large, it can lead to disruptions that affect financial stability and in turn jeopardise the sustainability of the whole exit strategy.”
Mr. Smaghi, also stated that much uncertainty lies within "the analytical framework that central banks have at their disposal in order to decide the optimal interest rate path.” Ideally, he noted that “the stance of monetary policy should be calibrated in such a way as to avoid an implicit easing of monetary conditions as the economy recovers.” However, one of the inherent problems with this framework is the difficulty incurred in estimating the “potential growth and the size of the output gap.” The ECB, however, has sought to reduce this type of risk by implementing a two-pillar strategy in which “monetary and credit aggregates have been used as indicators of a strengthened economy, while inflationary pressures were still subdued.”
One additional issue for consideration is the fact that “the exit from the non-standard measures is likely to be linked to the state of the financial markets, and in this respect can partly be disconnected from the interest rate policy.” While based on the framework of “the non-standard instruments implemented by the ECB, the exit from those instruments can take place before or after the interest rate decision, without major effects on it.” Mr. Smaghi cautioned, however, that, “if at the time of the exit a number of financial institutions are still addicted to central bank liquidity, the transmission channel of monetary policy might be impaired.”
Mr. Smaghi noted in his concluding remarks that it “is not the central bank’s task to continue providing liquidity to financial institutions which are not able to stand on their own feet, once the turmoil is over” but rather “the responsibility of the supervisory authorities, and ultimately of Treasuries, to address the problems of these addicted banks as soon as possible, through recapitalisation and restructuring, as appropriate, and to ensure that all banks in their jurisdictions can stand on their own feet even without the central bank’s facilities.”