Gobernador. Entrevista con Central Banking (229 KB)

Communication Department

4 January 2021

Hernández de Cos on ECB policy, crises responses and Basel reform

Interview with the Governor, Pablo Hernández de Cos, published in Central Banking

You took on your role as Bank of Spain governor and member of the European Central Bank's governing council in 2018 - but you had previously attended council meetings and served as adviser to the executive board. During your career, what would you highlight as the most important transformations that have taken place?

I've spent all my life in central banking, at the Bank of Spain or at the European Central Bank. What I've seen over the past two decades is a structural transformation both of the worries that central banks face and the tools they have to face them. At the very beginning of the European Monetary Union, there were some questions about whether it would work adequately. We all wanted to have the anchor of German monetary policy thinking. We succeeded.

And now, of course, we are in a completely different environment. Over the past decade, we have been worried about low inflation, more than the opposite. And we face the challenge of a very low natural interest rate environment, which leads to the effective lower bound of interest rates becoming more binding. These have led us to the expansion of the ECB's monetary policy tools, which was a complete novelty. Indeed now after some years using them, we have to stop calling them unconventional and start considering them conventional monetary policy tools. I would say this is the most important structural transformation that I've experienced.

Do you think the effectiveness of the various unconventional tools implemented over

the past decade are well understood as moving interest rates?

It was a learning process for all of us to understand them - including financial markets, the banking sector, non-financial companies and even households. For central bankers, the relative efficiency of the different tools is of course very important. And it´s clear that some tools are more efficient than others. We didn't have much experience before this practical use of them and we are still learning.

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On December 10, the Governing Council agreed to increase the pandemic emergency purchase programme's (PEPP) portfolio by €500 billion, and the period of net purchases to March 2022. However, it also said that if favourable financing conditions can be maintained without exhausting the envelope, it "need not be used in full". Does this rule out new increases to the portfolio? Are you concerned markets may interpret this wording as ECB's unwillingness to provide more stimulus?

It is true that there was a novelty in the statement released in December, indicating the PEPP envelope may not be used in full. At the same time, it was also mentioned that the PEPP envelope could indeed be increased, again, if required. Here, the key is to maintain favourable financing conditions. We want to give a signal of efficiency, in the sense that if we are able to maintain favourable financing conditions without using the full envelope, we will do so. But if this is not the case, for whatever reason, and we need to fully use what we have already approved or even to increase it, we are ready to do so as well.

Following this month's meeting, some have pointed out PEPP's extension is increasingly transforming it into a yield-curve control mechanism. Is this a fair assessment? Would you favour the formal adoption of the strategies currently implemented by the Bank of Japan or the Reserve Bank of Australia and target a specific yield limit?

We are still a fair distance from what you would call yield curve control. This is for two main reasons. First, yield curve control requires a commitment to purchase whatever amount necessary to keep yields at the targeted level. The PEPP does not incorporate such a commitment, because the envelope sets the maximum amount of net purchases to be conducted. The envelope may be increased, but that does not mean it can be raised without limit, which is a prerequisite of a pure, totally credible yield control policy. Secondly, yield curve control typically refers to the control of a single yield curve, for instance, the Japanese government bond yield curve, in the case of the Bank of Japan.

In our case, as president [Christine] Lagarde explained after our meeting in December, we define financial conditions in a very holistic way - meaning that we do not look at the yields of any particular issuer or sector, but to a broad set of indicators. That includes, for example, sovereign yields, corporate yields, lending rates to households or to corporates, or even lending flows.

I think yield curve control is an option worth exploring. The experience of these central banks suggests that, if sufficiently credible, yield curve control allows the central bank to achieve a yield curve configuration with a lower amount of actual purchases, hence, enhancing efficiency. It's also true that this strategy would be more complex in the eurozone because we don't have one, but 19 sovereign yield curves. You could still target all 19 curves, but as I noted before, that would require a commitment to flexibly buying as many sovereign bonds of those countries as needed - something that could be challenging from an operational and even a legal perspective.

An alternative would be to target the risk-free yield curve, for example the OIS [overnight index swap] curve in the eurozone. This could be coupled with a flexible use of our asset purchase programme to prevent sovereign yield curves from departing from the risk-free

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one to the extent this represents a risk to the smooth transmission of our monetary policy. This strategy would probably deliver similar outcomes. However, it's not something we have discussed yet.

The PEPP has evolved very rapidly over this year. And as you mentioned, it now has a very holistic goal targeting broader financial conditions. Looking beyond the pandemic, could this become the longer-term objective of the programme, in contrast to asset purchasing programme goals linked to the inflation target?

Financial conditions should be taken as an intermediate target. But of course, you shouldn't completely separate the intermediate objective regarding financial conditions from your inflation goal. This interrelation should be taken into account for any of the tools we are using. This means you shouldn't pursue a certain level of financial conditions per se, but only to the extent that they are compatible or they lead you to achieving your statutory policy objective. We shouldn't miss this interrelation.

Regarding Targeted Longer Term Refinancing Operations (TLTRO), the governing council increased banks' borrowing capacity from 50% to 55% of their eligible loans. Media reports say Philip Lane had put forward an increase to 60%, but the proposal encountered resistance. Some analysts deem it insufficient and say it could force weaker banks to revert to other funding sources. Is the measure enough for banks to offer adequate financing conditions over the coming year?

We know that a large number of eurozone banks are already at, or close to, their borrowing allowance for the TLTRO III operations. Another observation that is important in this regard is that we also know that for banks to actually use any additional TLTRO funds for lending to the real economy, they must have some unused borrowing allowance; otherwise, they would just use any new funds to pay off pre-existing TLTRO loans. Both observations led the governing council to think that an increase in the TLTRO allowance was warranted from a monetary policy perspective. Of course, if the number of banks at the new limit, or close to it, remains high, it would probably suggest the convenience of a further increase in that limit. But for that we will have to wait and see.

In relation to the PEPP, we've rescaled the programme capacity and extension as deemed necessary given current circumstances. But this is not the end of it- it will depend on the evolution of economy, the evolution of financial conditions, etc. Whether the current envelope is sufficient or not, time will provide us with the evidence we need to reach our conclusions.

One of the central aspects of the ECB's strategy review is the reform of the current inflation target. In August, the Federal Reserve unveiled a new strategy allowing inflation to rise over the target to offset periods below it. The ECB has also recorded many years clearly below its main policy goal. Would you support the adoption of average inflation targeting (AIT) at the ECB? What is wrong with having inflation below 2% if there is no risk of deflation?

Our starting point at the ECB is that we have this definition of price of stability of "below, but close to, 2%". In my view, this can be improved. It doesn't provide a clear objective.

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Here, a focal point at 2% is probably much better. It would be a move in the right direction, not only regarding clarification. In the current low natural interest rate environment, having a higher target would provide some additional buffer for nominal interest rates vis-à-vis the lower bound. This helps to explain why it is important not to be anchored to an inflation number that is too low. The probability of a situation emerging where the central banks is more constrained by the effective lower bound is higher. A third issue here is symmetry. I want the central bank to be perceived as symmetric, in the sense that it will react as strongly to inflation overshoots as to undershoots.

It would be important to adopt a new formulation that leaves no doubt about this symmetric nature. With the current wording of below, but close to, 2%, this still can be interpreted in an asymmetric way. It would be important to clarify this concept once and for all. The other key aspect is to define what symmetry means in practice. In my view, it should be interpreted as our determination to achieve symmetric outcomes. This means that if you've been below the target for a while, you should also accept inflation outcomes that are above the target for some time.

Even with a symmetric point target of 2% that it is interpreted in a symmetric way, it is obvious that, even there, frequent encounters with the lower bound would remain a possibility for nominal rates if the interest rate of equilibrium remains as low as it is estimated to be currently. And this would represent an asymmetry in our ability to act and stabilise the economy. I believe this constraint should be acknowledged and reflected in our monetary policy strategy. This is what the new monetary policy of the US Federal Reserve is trying to achieve - the average inflation-targeting element they are incorporating refers explicitly to how the central bank should act in the future following a period of below-target inflation.

Whether we have to incorporate it into the final objective, or simply take it into account when setting our policy and signalling for how long our policy still needs to remain accommodative, is something to be discussed.

Do you have a strong view on how the new inflation target should operate?

My strong view is related to three elements that I deem important. First, we need to clarify the target, and have a number that is understandable for everybody, and on which there are no doubts. Second, we need it to be higher than the current number, if only marginally higher, meaning for example 2%. Third, this target needs to be symmetric, and this symmetry needs to be interpreted as the central bank wanting symmetric outcomes. For me, all this is very relevant in the current context.

Some officials and academics are pointing out that average inflation targeting (AIT) entails policy communication challenges. 'Where would be the new upper limit for inflation? For how long would it be allowed to be over the target?' they ask. Some observers think the Fed has failed to address these questions. Do you think it is necessary to address them in order to better guide markets?

I think it's obvious that being more precise on the parameters of an AIT strategy would make it more transparent - and more effective, because it could guide markets in a more effective and accountable way. But at the same time, we know that fixing all those parameters with

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