ECB's Yves Mersch: ECB is attentive to potential side effects of policy

Keynote speech by Yves Mersch, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, at the celebration of INVESTAS’ 60th anniversary. Mersch warned that asset prices, particularly for real estate, are stretched and this “may in turn trigger future crises.”

“Vigilance is particularly warranted in the light of some signs that monetary policy is encouraging increased risk-taking and contributing to elevated asset price inflation and income inequality,” said Mersch, a policy hawk who has criticized easy policy in the past.

Introduction

The outlook for euro area economic activity and inflation at present warrants the highly accommodative monetary policy implemented by the ECB through our package of policy measures. Nonetheless, the Governing Council remains attentive to the potential side effects of those measures. Monitoring and analysing those side effects is part and parcel of the Governing Council’s ongoing monetary policy assessment and our recently announced strategy review.

Indeed, the prolonged period of substantial accommodation and the unconventional nature of our measures call for vigilance on the efficacy of the policy measures and might affect the strategic calibration and the appropriateness of the monetary policy stance. This vigilance is particularly warranted in the light of some signs that monetary policy is encouraging increased risk-taking and contributing to elevated asset price inflation and income inequality.

To my mind, this raises two concerns for the long-run efficacy of our measures, which I wish to discuss today.

The first is the contribution of stretched asset prices to vulnerabilities in the financial system, which may in turn trigger future crises. The second is the part they may play in creating a disparity between public perceptions of inflation and official measures. That disparity can undermine public support for our unconventional measures and eventually erode trust in the ECB.

Key notes

• Current asset prices at ‘very elevated levels’. 
• Rrisks of asset price correction are increasing.
• Euro-area outlook warrants highly accommodative stance.
• Preferable for monpol to incorporate financial stability concerns into policy deliberations.
• ECB is attentive to potential side effects of policy.
• Good reasons to believe that macroprudential policy in euro area is currently constrained in effectiveness.
• There may be a significant gap between what households perceive to be the increase in their cost of living and what is measured by the HICP.
• Tightening monetary policy to cool asset prices would reduce the likelihood and severity of financial crises but comes at a cost of below-target inflation.
• That is a trade-off that needs to be balanced carefully, taking into account the risks on both sides.
• There is ... no clean separation between the pursuit of monetary stability and that of financial stability in the medium term.

FX implications

These are all very much repeats of what is already known by the market. Risks of bubbles galore due to the ultra-easy monetary policy.

Instead, the better focus would be on the fact that we have a new political stance at the ECB with Christine Lagarde at the helm. "I will have my own style," she told reporters when she took over the position."Don't over-interpret, don't second guess, don't cross-reference. I am going to be myself and therefore probably different."  

As for the economy, the risks "remain tilted to the downside but have become somewhat less pronounced,"

– Lagarde warned back in December.

In her first meeting, as expected, the ECB said it would hold interest rates steady, while pledging to continue purchases of €20 billion ($22.3 billion) in financial assets per month for "as long as necessary."

While the composite PMI remained unchanged at 50.9 this month, there were some green shoots appearing to start the year with some moderate optimism. The manufacturing PMI increased from 46.1 to 47.5 in January, an area of the economy that has be faltering. since the US/Sino trade deal, the sentiment among manufacturers is improving rapidly, meaning that expectations for a 2020 recovery are increasing. However, there is some way to go yet and there are always the risks that the US will target the EU trade agreements in due course. Also, with interest rates at historic lows, the ECB may need to increase pressure on eurozone governments to step up fiscal spending down the line. 

One of Lagarde's biggest tasks will be completing a top-down review of the central bank's strategy within the next year. When she came into the position, she indicated on Thursday that the bank will scrutinize the tools it's used to juice the economy in the past decade and consider new ones. For now, the euro will find some solace in the recent data, with support structure at 1.0980 and 1.0860. However, risk-off flows will likely weigh on the euro and support the dollar.