Extracts from The Speech by Benoît Cœuré
We have two main instruments to flatten the yield curve across the full spectrum of maturities. The first is forward guidance, which works both by anchoring expectations about the level of future short-term rates, and by reducing the volatility around that level. However, forward guidance is only credible over the horizon of visibility of the monetary policy committee. If the central bank intends to steer interest rates at maturities beyond that horizon, it has to do so by directly targeting the term premium through private or public asset purchases.
As our short-term rates have fallen towards the lower bound, and hence the signalling power of rate movements has decreased, the ECB has progressively resorted to both these instruments. Interestingly, both measures – forward guidance and asset purchases – have been reinforced by the fact that the effective lower bound has proven to be slightly negative. When policy interest rates reach zero, even with credible forward guidance the term structure can steepen as markets anticipate that future short-term rates can only rise. If however they can be convinced that the lower bound for short-term rates is not zero but can be made negative, then the probability distribution of future rate movements changes. After we introduced our negative deposit rate last year we saw long-term interest rates starting to flatten. The probability distribution of future EONIA rates (with the forward rate standing at -15 basis points at end-2015) indeed includes an expectation that our deposit facility rate can be lowered further.
A negative deposit rate can also complement our asset purchase programme by inducing banks which are selling securities to the Eurosystem, and receiving bank reserves in return, to lend on those balances. It compensates the lack of capital relief for banks in a regulatory environment which treats government bonds as risk free. In this way it can increase the velocity of circulation of reserves and accelerate the portfolio rebalancing transmission channel.
As you know, this combination of measures has created strong price effects in certain asset markets, going beyond what many observers initially anticipated. We have always stressed, however, that the objective of our programme is to influence prices but not to impair price discovery. For this reason I do not see the recent reversal in the price of Bunds and other sovereign bonds as a cause for concern, insofar as it reflects a market correction, recreates two-way risk in the market and reflects the fact that, as our programme takes effect, some of the more pessimistic assumptions of future growth and inflation trends are being revised. It is the rapidity of the reversal that worries me more. After several similar episodes, it is yet another incident of extreme volatility in global capital markets showing signs of reduced liquidity.
Against this background, we are also aware of seasonal patterns in fixed-income market activity with the traditional holiday period from mid-July to August characterised by notably lower market liquidity. The Eurosystem is taking this into account in the implementation of its expanded asset purchase programme by moderately frontloading its purchase activity in May and June, which will allow us to maintain our monthly average of €60 billion, while having to buy less in the holiday period. If need be, the frontloading may be complemented by some backloading in September when market liquidity is expected to improve again. The slightly higher purchase volume that market analysts may observe in the coming weeks is therefore unrelated to the recent episode of market volatility.